Preliminaries The risk-return tradeoff Utility functions

Lecture 2: Risk and return
SAPM [Econ F412/FIN F313 ]

Ramana Sonti

BITS Pilani, Hyderabad Campus

Semester II, 2015-16

1/12 Lecture 2: Risk and return Ramana Sonti

Preliminaries The risk-return tradeoff Utility functions Agenda 1 Preliminaries Introduction 2 The risk-return tradeoff Example Indifference curves 3 Utility functions Quadratic utility Example revisited 2/12 Lecture 2: Risk and return Ramana Sonti .

there are two things we can do with our income: • consume • save (and invest) • Why invest? • because we want to trade consumption inter-temporally (across periods) • in the absence of investment alternatives. and make our money work for us • Bottom Line: Saving (and investment) is simply a way of postponing today’s consumption to tomorrow 3/12 Lecture 2: Risk and return Ramana Sonti .Preliminaries The risk-return tradeoff Utility functions Introduction Investments • Households (people like you and me). earn income. we would simply store rupees under one’s mattress • we earn a return on our investment. Typically.

Preliminaries The risk-return tradeoff Utility functions Introduction Investments trade consumption across time Trading consumption across time Consumption tomorrow → 117 • Not suprisingly. there are many alternative investments available 110 17% rate of return • Early chapters of BKM(M) describe details of some available financial 10% rate of return instruments and markets • This picture hides a key issue: the differing risk of the investments 100 Consumption today→ INVA .Term 4 .2007 .Indian School of Business 4 • Not seen in the above figure: the risk and return of the investments 4/12 Lecture 2: Risk and return Ramana Sonti .

Term 4 . there are many alternative investments available 110 17% rate of return • Early chapters of BKM(M) describe details of some available financial 10% rate of return instruments and markets • This picture hides a key issue: the differing risk of the investments 100 Consumption today→ INVA .Preliminaries The risk-return tradeoff Utility functions Introduction Investments trade consumption across time Trading consumption across time Consumption tomorrow → 117 • Not suprisingly.2007 .Indian School of Business 4 • Not seen in the above figure: the risk and return of the investments 4/12 Lecture 2: Risk and return Ramana Sonti .

000 • Choice 1: A risk-free investment which will grow to 105.6.000 with a probability 0.000 100.4 × −20%) = 22% 5/12 Lecture 2: Risk and return Ramana Sonti .Preliminaries The risk-return tradeoff Utility functions Example Trade-off between risk and return: An example Consider the investment choices facing an investor with 100.6 × 50%) + (0. or decrease to 80.000 100.000 − 1 = 50% and 80.000 100.4 Return comparison • The risk-free rate here is rf = 105.000 − 1 = 5% • The returns of the risky investment in each state are 150.000 − 1 = −20% respectively • The expected return on the risky investment is (0.000 in one period • Choice 2: A risky investment which will grow to 150.000 with a probability 0.

000 with a probability 0.Preliminaries The risk-return tradeoff Utility functions Example Trade-off between risk and return: An example Consider the investment choices facing an investor with 100.4 × −20%) = 22% 5/12 Lecture 2: Risk and return Ramana Sonti .6.4 Return comparison • The risk-free rate here is rf = 105.000 100.000 − 1 = −20% respectively • The expected return on the risky investment is (0.000 100. or decrease to 80.6 × 50%) + (0.000 • Choice 1: A risk-free investment which will grow to 105.000 100.000 with a probability 0.000 in one period • Choice 2: A risky investment which will grow to 150.000 − 1 = 5% • The returns of the risky investment in each state are 150.000 − 1 = 50% and 80.

22)2 + 0.Preliminaries The risk-return tradeoff Utility functions Example Risk and decision making Traditional risk measures • Variance of the risky return = 0.1176 √ • Standard deviation= (0.29% risk? Choice depends upon.1176) = 34..29% Comparison • Choice 2 has an expected return which is 17% more than the risk-free rate • Choice 2 also has a standard deviation of 34.29% • How can we tell if the 17% extra expected return is commensurate with the 34.50 − 0.4(−0. • Investor’s attitude towards risk which we need to specify: this is the domain of utility theory • Models that facilitate mathematical comparison of risk and return of different investment choices are known as asset pricing models 6/12 Lecture 2: Risk and return Ramana Sonti .22)2 = 0.20 − 0..6(0.

1176) = 34..6(0.Preliminaries The risk-return tradeoff Utility functions Example Risk and decision making Traditional risk measures • Variance of the risky return = 0.29% Comparison • Choice 2 has an expected return which is 17% more than the risk-free rate • Choice 2 also has a standard deviation of 34.22)2 + 0.29% risk? Choice depends upon.22)2 = 0.29% • How can we tell if the 17% extra expected return is commensurate with the 34.1176 √ • Standard deviation= (0..50 − 0.20 − 0.4(−0. • Investor’s attitude towards risk which we need to specify: this is the domain of utility theory • Models that facilitate mathematical comparison of risk and return of different investment choices are known as asset pricing models 6/12 Lecture 2: Risk and return Ramana Sonti .

. • Investor’s attitude towards risk which we need to specify: this is the domain of utility theory • Models that facilitate mathematical comparison of risk and return of different investment choices are known as asset pricing models 6/12 Lecture 2: Risk and return Ramana Sonti .20 − 0.29% Comparison • Choice 2 has an expected return which is 17% more than the risk-free rate • Choice 2 also has a standard deviation of 34..29% • How can we tell if the 17% extra expected return is commensurate with the 34.4(−0.1176 √ • Standard deviation= (0.22)2 = 0.6(0.50 − 0.Preliminaries The risk-return tradeoff Utility functions Example Risk and decision making Traditional risk measures • Variance of the risky return = 0.1176) = 34.29% risk? Choice depends upon.22)2 + 0.

i. Clearly. we are greedy • Assumption 2: Investors are risk averse The essence of risk aversion • Consider a gamble where you flip a coin and get 15 if it turns up heads..e.Preliminaries The risk-return tradeoff Utility functions Example Investor behavior Basic assumptions • Assumption 1: Investors like more returns with less risk. and 5 if it turns up tails. the expected payoff of the gamble is 10 • Question: How much would you pay as an entry fee to be able to play this gamble? • If you are willing to pay 12 (> 10): you are risk preferred • If you are willing to pay 10 (= 10): you are risk neutral • If you are willing to pay 8 (< 10): you are risk averse 7/12 Lecture 2: Risk and return Ramana Sonti .

Preliminaries The risk-return tradeoff Utility functions Indifference curves A general indifference curve • All combinations of the two goods that result in the same utility (or happiness) lie on an indifference curve 12 10 8 Beer 6 4 2 0 0 1 2 3 4 5 6 Pizza 8/12 Lecture 2: Risk and return Ramana Sonti .

E(r) Increasing utility Standard Deviation. the curve is steeper as you climb 9/12 Lecture 2: Risk and return Ramana Sonti .Preliminaries The risk-return tradeoff Utility functions Indifference curves Risk-return indifference curves U3 U1 U2 Expected Return. σ(r) Observations • Assumption 1 (non-satiation) means that utility increases as we proceed in the northwesterly direction • Assumption 2 (risk aversion) means that at lower levels of risk. it takes a small amount of return to induce the investor to take a given amount of risk. Since risk averse investors want to be increasingly compensated with increasing risk.

σ(r) Observations • Assumption 1 (non-satiation) means that utility increases as we proceed in the northwesterly direction • Assumption 2 (risk aversion) means that at lower levels of risk. E(r) Increasing utility Standard Deviation. Since risk averse investors want to be increasingly compensated with increasing risk. it takes a small amount of return to induce the investor to take a given amount of risk. the curve is steeper as you climb 9/12 Lecture 2: Risk and return Ramana Sonti .Preliminaries The risk-return tradeoff Utility functions Indifference curves Risk-return indifference curves U3 U1 U2 Expected Return.

Preliminaries The risk-return tradeoff Utility functions Indifference curves Comparing different investors More risk-averse E(r) investors have E(r) Less risk-averse steeper investors have indifference curves flatter indifference 19% curves 14% 12% 15% 20% σ(r) 15% 20% σ(r) 10/12 Lecture 2: Risk and return Ramana Sonti .

Preliminaries The risk-return tradeoff Utility functions Quadratic utility The quadratic utility function • Utility functions are ways of representing investor preferences • We shall use the quadratic utility function 1 U(E(r). • indifference curves with increasing utility move to the north-west • More risk averse investors (with greater values of A) have steeper indifference curves 11/12 Lecture 2: Risk and return Ramana Sonti . σ (r)) = E(r) − Aσ 2 (r) 2 • A is called the coefficient of risk aversion • A > 0: Risk averse investor • A = 0: Risk neutral investor • A < 0: Risk loving investor • Note that the quadratic utility function satisfies our assumptions of non-satiation and risk aversion • Confirm for yourself that with this utility function.

0436 • Clearly.0. E(r) = 0.Preliminaries The risk-return tradeoff Utility functions Example revisited Back to our example • Recall the parameters of our earlier example: rf = 0. choices are not binary.05 • Utility with risky asset = 0.22 − (0.34292 ) = 0. the risky asset is the better choice • In practice.5 × 3 × 0.5 × 3 × 02 ) = 0.22.05 − (0.05. for this investor. the risk-free asset is the better choice • Verify that for A = 2. of course – we have the ability to form portfolios of these assets 12/12 Lecture 2: Risk and return Ramana Sonti .3429 • Let’s calculate the utility of a particular investor with A = 3 for investment choices 1 and 2 • Utility with risk-free asset = 0. σ (r) = 0.