stuff from lesson 2 (week 1) Flashcards
speculation
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
commensurate gain
a positive expected profit beyond the risk-free alternative
–> the risk premium, the incremental expected gain from taking on the risk
considerable risk
the risk is sufficient to affect the decision
the central difference between gambling and speculation
the lack of “commensurate gain”
Personal expectations
–> Expected payoff could be zero in gambling
a gamble
the assumption of risk for enjoyment of the risk itself
how do we turn a gamble into a speculative prospect?
we need an adequate risk premium for compensation to risk-averse investors for the risks that they bear
heterogeneous expectations
individuals perceiving different probabilities for the same scenarios
–> investors on each side of a financial position see themselves as speculating rather than gambling
The ideal way to resolve heterogeneous expectations
to merge the information
for each party to verify that he or she possesses all relevant information and processes the information properly
a fair game
A prospect that has a zero-risk premium
–> rejected by risk averse investors
risk averse investors
consider only risk-free or speculative prospects with positive risk premiums
reject fair games or worse
utility
a welfare score to competing investment portfolios based on the expected return and risk of those portfolios
The utility value
may be viewed as a means of ranking portfolios
–> Higher utility values are assigned to portfolios with more attractive risk–return profiles
formula for utility
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
the utility provided by a risk-free portfolio
simply the rate of return on the portfolio, since there is no penalization for risk
The certainty equivalent rate of a portfolio
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
risk-neutral investors
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
what is the certainty equivalent rate of a portfolio for a risk-neutral investor?
simply the portfolio’s expected rate of return
A risk lover
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
the indifference curve
the curve in the graph and shit
the types of risk that can affect a company’s economic performances and our portfolios
systematic risk (market risk)
company specific risk
diversification
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
why can’t diversification eliminate all risk?
because virtually all securities are affected by the common macroeconomic factors (systematic risk)
the insurance principle
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
systematic risk (market risk)
The risk that remains even after extensive diversification
affects all firms and is inevitable
nondiversifiable risk
the two tasks of portfolio construction
Allocation of overall portfolio to safe assets or risky assets
determination of composition of the risky portion of the portfolio
Portfolio theory starts with what?
with the capital allocation decision
Choosing the amount of money you need to allocate to a risky portfolio is a personal decision that depends mainly on what?
one one’s attitude towards risk
Rational investors
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
Heterogeneous expectations
based on information and all investors should have access to
one’s utility value depends on what?
Risk (measured by volatility)
Reward or compensation (measured by expected returns)
Personal preference (measured by Risk Aversion Coefficient)
In selecting risky portfolios, investors choose the investment that delivers the highest or lowest utility?
the highest utility
the value of A for risk neutral investors
0
the value of A for risk loving investors
<0
the value of A for risk averse investors
> 0
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?
the utilities generated by these two investments are equal
in practice, which assets are considered good proxies for Risk Free rate? why?
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
CAL – Capital Allocation Line
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
CML
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
CAL – Capital Allocation Line formula
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
when does the CAL become the CML?
when our risky portfolio “P” happens to be the Market Portfolio (M)
the formula stays the same
the link between y and our utility
we have to choose a value of y, so the proper allocation of our risky asset, which will increase our utility
using indifference curves, which is the optimal portfolio?
the one in which one of the indifference curves is tangent to either the CAL or CML
what is the value of A in indifference curves?
A is the slope
A is fixed per investor
risk averse have steep or flatter indifference curves? why?
steeper curves because they require more return to compensate for more risk
Portfolio construction
Allocation of overall portfolio to safe assets or risky assets
Determination of composition of the risky portion of the portfolio
Portfolio theory
starts with the capital allocation decision
Choosing the amount of money you need to allocate to a risky portfolio is a personal decision that depends mainly on what?
attitude towards risk
