stuff from lesson 2 (week 1)

Question 1

speculation

Answer 1

the assumption of considerable business risk in obtaining commensurate gain

–> this definition is useless without first specifying what is meant by “commensurate gain” and “considerable risk”

undertaken because one perceives a favorable risk–return tradeoff

taking a risk with the expectation of being compensated for it by appropriate returns

Question 2

commensurate gain

Answer 2

a positive expected profit beyond the risk-free alternative

–> the risk premium, the incremental expected gain from taking on the risk

Question 3

considerable risk

Answer 3

the risk is sufficient to affect the decision

Question 4

the central difference between gambling and speculation

Answer 4

the lack of “commensurate gain”

Personal expectations

–> Expected payoff could be zero in gambling

Question 5

a gamble

Answer 5

the assumption of risk for enjoyment of the risk itself

Question 6

how do we turn a gamble into a speculative prospect?

Answer 6

we need an adequate risk premium for compensation to risk-averse investors for the risks that they bear

Question 7

heterogeneous expectations

Answer 7

individuals perceiving different probabilities for the same scenarios

–> investors on each side of a financial position see themselves as speculating rather than gambling

Question 8

The ideal way to resolve heterogeneous expectations

Answer 8

to merge the information

for each party to verify that he or she possesses all relevant information and processes the information properly

Question 9

a fair game

Answer 9

A prospect that has a zero-risk premium

–> rejected by risk averse investors

Question 10

risk averse investors

Answer 10

consider only risk-free or speculative prospects with positive risk premiums

reject fair games or worse

Question 11

utility

Answer 11

a welfare score to competing investment portfolios based on the expected return and risk of those portfolios

Question 12

The utility value

Answer 12

may be viewed as a means of ranking portfolios

–> Higher utility values are assigned to portfolios with more attractive risk–return profiles

Question 13

formula for utility

Answer 13

U = ER - 1/2A · σ^2

U: the utility value

A: an index of the investor’s aversion to taking on risk

–> The extent to which variance lowers utility depends on A, the investor’s degree of risk aversion

–> More risk-averse investors (who have the larger A’s) penalize risky investments more severely

the formula is consistent with the notion that utility is enhanced by high expected returns and diminished by high risk

Question 14

the utility provided by a risk-free portfolio

Answer 14

simply the rate of return on the portfolio, since there is no penalization for risk

Question 15

The certainty equivalent rate of a portfolio

Answer 15

the rate that risk-free investments would need to offer with certainty to be considered equally attractive to the risky portfolio

The utility generated by the risky portfolio equal to the utility generated by the risk free investment

Question 16

risk-neutral investors

Answer 16

judge risky prospects solely by their expected rates of return

The level of risk is irrelevant to the risk-neutral investor, meaning that there is no penalization for risk

Question 17

what is the certainty equivalent rate of a portfolio for a risk-neutral investor?

Answer 17

simply the portfolio’s expected rate of return

Question 18

A risk lover

Answer 18

willing to engage in fair games and gambles

–> will take a fair game because their upward adjustment of utility for risk gives the fair game a certainty equivalent that exceeds the alternative of the risk-free investment

this investor adjusts the expected return upward to take into account the “fun” of confronting the prospect’s risk

Question 19

the indifference curve

Answer 19

the curve in the graph and shit

Question 20

the types of risk that can affect a company’s economic performances and our portfolios

Answer 20

systematic risk (market risk)

company specific risk

Question 21

diversification

Answer 21

not putting all the eggs in one basket

we include additional securities in your risky portfolio to spread out our exposure to firm-specific factors (company specific risk)

–> portfolio volatility (risk) should continue to fall

Question 22

why can’t diversification eliminate all risk?

Answer 22

because virtually all securities are affected by the common macroeconomic factors (systematic risk)

Question 23

the insurance principle

Answer 23

the reduction of risk to very low levels in the case of independent risk because belief that an insurance company depends on the risk reduction achieved through diversification when it writes many policies insuring against many independent sources of risk

Question 24

systematic risk (market risk)

Answer 24

The risk that remains even after extensive diversification

affects all firms and is inevitable

nondiversifiable risk

Question 25

the two tasks of portfolio construction

Answer 25

Allocation of overall portfolio to safe assets or risky assets

determination of composition of the risky portion of the portfolio

Question 26

Portfolio theory starts with what?

Answer 26

with the capital allocation decision

Question 27

Choosing the amount of money you need to allocate to a risky portfolio is a personal decision that depends mainly on what?

Answer 27

one one’s attitude towards risk

Question 28

Rational investors

Answer 28

avoid investing in a risky asset unless they are compensated for the risk they are taking by additional expected return

invest in risky assets only if they anticipate higher returns that is commensurate to the risk they are accepting

Question 29

Heterogeneous expectations

Answer 29

based on information and all investors should have access to

Question 30

one’s utility value depends on what?

Answer 30

Risk (measured by volatility)

Reward or compensation (measured by expected returns)

Personal preference (measured by Risk Aversion Coefficient)

Question 31

In selecting risky portfolios, investors choose the investment that delivers the highest or lowest utility?

Answer 31

the highest utility

Question 32

the value of A for risk neutral investors

Answer 32

0

Question 33

the value of A for risk loving investors

Answer 33

<0

Question 34

the value of A for risk averse investors

Answer 34

> 0

Question 35

if an investor, either risk neutral, loving, or averse, is indifferent between two alternative investments, what does it mean for the utilities generated by the two investments?

Answer 35

the utilities generated by these two investments are equal

Question 36

in practice, which assets are considered good proxies for Risk Free rate? why?

Answer 36

short Term Treasury Bills

They are issued by the government making them default free

Their short term nature (less than a year) makes them immune to
fluctuations in interest rates and particularly the inflation factor

Question 37

CAL – Capital Allocation Line

Answer 37

The capital allocation line (CAL) makes up the allotment of risk-free assets and risky portfolio for an investor

a line created on a graph of all possible combinations of risk-free and risky assets

the graph displays the return investors might possibly earn by assuming a certain level of risk with their investment

Question 38

CML

Answer 38

a line created on a graph of all possible combinations of risk-free and risky assets

the graph displays the return investors might possibly earn by assuming a certain level of risk with their investment

is a special case of the CAL where the risk portfolio is the market portfolio

Question 39

CAL – Capital Allocation Line formula

Answer 39

ERc = RF + y · (ERp - RF)

y being the allocation of the risky asset

ERc = RF + σc · (ERp - RF)/σp

The above equation states that investors expect a return on their complete risky portfolio that is higher than the Risk Free Rate (RF) by an amount equal to y

Question 40

when does the CAL become the CML?

Answer 40

when our risky portfolio “P” happens to be the Market Portfolio (M)

the formula stays the same

Question 41

the link between y and our utility

Answer 41

we have to choose a value of y, so the proper allocation of our risky asset, which will increase our utility

Question 42

using indifference curves, which is the optimal portfolio?

Answer 42

the one in which one of the indifference curves is tangent to either the CAL or CML

Question 43

what is the value of A in indifference curves?

Answer 43

A is the slope

A is fixed per investor

Question 44

risk averse have steep or flatter indifference curves? why?

Answer 44

steeper curves because they require more return to compensate for more risk

Question 45

Portfolio construction

Answer 45

Allocation of overall portfolio to safe assets or risky assets

Determination of composition of the risky portion of the portfolio

Question 46

Portfolio theory

Answer 46

starts with the capital allocation decision

Question 47

Choosing the amount of money you need to allocate to a risky portfolio is a personal decision that depends mainly on what?

Answer 47

attitude towards risk