Term
| why doen't investors like risk? what is the underlying assumption? |
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Definition
| investors are risk adverse |
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Term
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Definition
U E(r)↑ risk↓
utitly excpected return |
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Term
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Definition
U E(r)↑ utitly excpected return |
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Term
| Risk Taker (seeker, lover) |
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Definition
U E(r)↑ risk↑ utitly excpected return gamblers their expected return is negative willing to take negative expected return in hopes of a super high possible return |
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Term
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Definition
just bc i'm risk adverse doesn't mean I won't take risk willing to take risk as long as I get compensated for the risk plus an excess return |
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Term
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Definition
convinient measures: standard deviation variance co-variance (mathamatically they work, but they're not always accurate) other realistic measures: probability |
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Term
| characteristics of probabilty distribution |
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Definition
1) Mean: most likely value
2) Variance or standard deviation: volatility
3) Skewness: symmetry
* If a distribution is approximately normal, the distribution is described by characteristics 1 and 2 |
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Term
| Rates of Returns: stocks vs bills vs bonds |
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Definition
- stocks: high variance
- t bills: very stable
- bond: higher return than tbills more stable than stocks
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Term
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Definition
| even probabilty of returns |
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Term
| Skewed Distribution: Large Negative Returns Possible |
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Definition
likely probability for positive return however, possiblity to f big loss mean in bellow median most stock returns and indexs are like this |
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Term
| Measuring Mean: Expected Returns |
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Definition
expected returns - use the E(r) formula
- 1st we need a discount rate
- using subjective probabilities for the coming years
- state of economy - probability - return
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Term
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Definition
basically... (probility of economic condition * (rate of return - expected return)) Variance = [.2*(-10 – 9.5) 2 + .5*(8 – 9.5)2 + .3*(25 - 9.5)2]
Variance = 76.05 + 1.125 + 72.075 = 149.25
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Term
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Definition
squre root of variance Standard deviation = [ 149.25] 1/2 = 12.22% |
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Term
| Real Rate VS Nominal Rate |
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Definition
Real Rate: what u actuall get, includes inflation Nominal Rate: the listed rate, what they tell you |
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Term
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Definition
Approximation
real rate = nominal rate - inflation
r ≈ R - i
Exact
1+r = (1 + R) / (1 + i)
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Term
| What happens w/ inflation of 2-3%? |
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Definition
- will always effect the purchasing power of the individual
- must be correlated w/ unemployment rate
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Term
We usually assume a T-bill is a risk-free asset. What type of risk do we mean here?
Can you think of a risk associated with T-bills?
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Definition
there are risks of inflation b4 the fed cut rates the real rate of t-bill was negative, this should never happen |
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Term
| risk premium or excess returns |
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Definition
return on risk minus risk free rate ri - rf |
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Term
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Definition
the highest possible losses and returns therefore, the highest standard deviation |
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Term
| frequency distributions of holding period returns |
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Definition
- small company stocks
- large co stocks
- most normal
- flatest std dev
- LT gov bonds
- skewed
- big+ returns
- small - returns
- T-bills
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Term
Split investment funds between safe and risky assets
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Definition
- Risk-free asset: T-bills
- Risky asset: stock (or a portfolio) |
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Term
| say u buy a t-bill and shares in a risky porfolio... how do u find return on entire portfolio? |
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Definition
determine proportion of complete portfolio Each individual must decide how much to hold in the risky asset and in the risk-free asset
E(rp) = expected return on risky portfolio
rf = return on risk-free asset
E (rc) = expected return on complete or combined portfolio
y = percent of total $$ invested in risky asset
E(rc) = yE(rp) + (1 - y)rf
σc= y*σp
We can rearrange à E(rc) = rf + y[E(rp) – rf] |
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Term
| For example, for y = .75 what is E(rc) , given that the risk-free rate is 7%, the expected return on the risky portfolio is 15%, and the standard deviation on the risky portfolio is 22% ? |
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Definition
E(rc) = 13% .75(15) + .25(7) = 13 Std Dev = .75(22) = 16.5% |
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Term
| Borrowing Constraints and the CAL |
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Definition
In reality, non-government investors cannot borrow at the risk-free rate
The risk of the borrower defaulting on the loan causes the lender to demand a higher interest rate on the loan |
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