Risk and return

Question 1

What is Markowitz risk premium

Answer 1

Risk Premium = expected wealth - certainty equivalent wealth

Question 2

Explain how the concept of utility is linked to the risk and return of an investment.

Answer 2

Concept of utility implies the differences of investor’s choices that they make under risky circumstances, each choices devires comparable utility satisfaction from investor’s point of view. In economics Utility is related to wealth. Each investment choices are a bundle of risk and return combination and the choices of these assets affect investors wealth.

If the question is longer then you can draw a utility graph (with a budget line) and explain it and you can draw a risk-return diagram and explain it.

Question 3

There are many theories that describe decisions between alternatives that involve risk. Briefly outline 2 of these theories, giving examples.

Answer 3

Prospect Theory and Anomalies in Risk Behavior.

This theory describes decisions between alternatives that involve risk.

• The disposition effect : the tendency of investors to sell shares whose price has increased while holding on to assets that have dropped in value. Investors are less willing to recognize losses and more willing to recognize gains.
• The reflection effect : it refers to having opposite preferences for gambles differing in the sign of the outcome.

Ex: most people ‘d prefer a certain gain of €20 over a 1/3 chance of gaining €60, whereas the same people ‘d choose a 1/3 chance of losing €60 over a certain loss of €20

• The endowment effect: people place a higher value on a good that they own than an identical good they do not own.

Question 4

Give some examples of how someone would demonstrate that they are:

• a risk lover
• risk averse

Answer 4

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Question 5

Write a brief note explaining the equity premium puzzle.

Answer 5

• Equity Premium Puzzle: describes the fact that the premium demanded by investors for equity is out of line with the risk involved. The size or magnitude of the premium will suggest either the risk premium is huge or that people are hugely risk averse, neither of which have been proven

Number of reasons are that
• The current models to price risk are incorrect
• Historical rates we have stated are not very accurate

Selection bias - most of the studies carried out on a larrge successful market such as US,UK equity market

Survival bias - studies tend to exclude those who did not survive.

Question 6

How ARA is measured and what does it mean?

Answer 6

= - U”/ U’

To see whether risk aversion is decreasing or increasing?

Question 7

Separation principle outline assumptions and principle itself

Answer 7

6 assumptions
Consumers optimizing consumption
Producer optimizing physical investment

Question 8

Markowitz vs Arrow-Pratt

Answer 8

They both measures the risk premium to determine whether someone should take a gamble or not
Markowitz method is able to determine the risk premium on an asymmetric gambles but was not able to tell whether someone is likes to gamble or not
Whereas arrow Pratt deals with asymmetric gambles but are able to determine behavior of the gambler and it works for calculating relatively low level risk with precition