Lecture 3 (Topic 4): Choice under Uncertainty Part 1

- Axiom of Probability:
 1: Non-negativity (probabilities cannot be negative)
 2: Normalisation (probabilities sum to 1)
 3: Additivity (probabilities of two disjoint events in a union is equal to
the sum of their probabilities)

- Expected variance and variance are able to be calculated for a lottery:

 Consumers care about risk as well as expected value
- Standard Deviation: Degree of spread within a set of data

- Expected Utility Theory:

 A choice is always possible (completeness)
 Transitivity
 Continuity
 Independence
- All four axioms must be satisfied for a preference to be represented by a utility
function:
 Independence is a very important axiom for the utility function to hold

- Risk Neutral investor utility is equal to the expected value of the function

- Concave: Graph is above a segment connecting two points together

- Convex: Graph is below a segment connecting two points together

- In a fair lottery the expected value is equal to zero

- More risk averse investors have a greater concave

- Risk Premium = π = Expected Lottery Value – Certainty Equivalent

- A higher certainty equivalent = Being more risk loving in nature

- All individuals will invest into an asset with a positive net return regardless of risk
profiles

- Absolute Risk Aversion: Deals with nominal investment

- Relative Risk Aversion: Deals with proportional investment

Lecture 4 (Topic 4): Choice under Uncertainty Part 2

- The level of risk tolerance is determined by many factors
- Equity Premium Puzzle: Average equity risk premium is too high

- Covariance and the correlation coefficient share the same sign:

 It can either be positive, negative or zero
 Both figures measure how the two returns move relative to each other

- Straight positive line: ρ = 1

- Straight negative line: ρ = -1
- No correlation: ρ = 0
  Returns are either uncorrelated or the asset is risk-free (and earns the
same constant return regardless of what the other assets are earning)

- All portfolios will lie on the same risk-return frontier:

 It is possible to hold a zero risk portfolio if ρ = -1
 Portfolios which do not lie on the risk-return frontier are inefficient
 Efficient Frontier: Portfolios lying on the top half of the risk-return
frontier

- Transformation Line: Risk-free lending/borrowing plus a proportion of investment

into a risky asset
 Return is a linear function of its risk

 The CML is the best transformation line

 100% lending: Invest all the money at the risk-free rate
 Can also short-sell the risky asset and move along the transformation
line to the right
 Implies that we have the same companies and hold the same
proportion of the risky market in our portfolio

Mean-Variance Model
- Model proposes that the only two things investors care about is mean and variance:
 Utility is dependent only upon expected return and variance

- The shape of the minimum variance curve is dependent on the asset’s correlation
coefficient

- CAPM is derived from the mean-variance model

 x-axis is beta since the CAPM line tells you how much return you can
expect based off the stock’s correlation with the market