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Risk and Risk Aversion

Chapter 6

293 6-2 1-2 .4(80=122)2 = 1.176.Risk .6 (150-122)2 + .4(80) = 122 s2 = p[W1 .E(W)]2 + (1-p) [W2 .4 W2 = 80 Profit = -20 E(W) = pW1 + (1-p)W2 = 6 (150) + .E(W)]2 = .000 s = 34.Uncertain Outcomes W1 = 150 Profit = 50 W = 100 1-p = .

4 Risk Free T-bills W2 = 80 Profit = -20 Profit = 5 Risk Premium = 17 6-3 1-3 .Risky Investments with Risk-Free Risky Inv. W1 = 150 Profit = 50 100 1-p = .

.Risk Aversion & Utility Investor’s view of risk Risk Averse Risk Neutral Risk Seeking Utility Utility Function U = E ( r ) .005 A s 2 A measures the degree of risk aversion 6-4 1-4 .

.22 .005 A (34%) 2 Risk Aversion A Value High 5 -6.005 A s 2 = .90 3 4..66 Low 1 16.Risk Aversion and Value: U = E ( r ) .22 T-bill = 5% 6-5 1-5 .

Dominance Principle Expected Return 4 2 1 Variance or Standard Deviation 3 • 2 dominates 1. has a higher return 6-6 1-6 . has a higher return • 2 dominates 3. has a lower risk • 4 dominates 3.

Utility and Indifference Curves Represent an investor’s willingness to tradeoff return and risk.0 25.9 2 2 6-7 1-7 .005As2 20. Example Exp Ret 10 15 St Deviation U=E ( r ) .5 2 2 20 25 30.0 33..

Indifference Curves Expected Return Increasing Utility Standard Deviation 6-8 1-8 .

Expected Return Rule 1 : The return for an asset is the probability weighted average return in all scenarios. E (r ) =  P( s )r ( s ) s 6-9 1-9 .

Variance of Return Rule 2: The variance of an asset’s return is the expected value of the squared deviations from the expected return. P( s)[ r ( s)  E (r )] s = s 2 2 6-10 1-10 .

with the portfolio proportions as weights.Return on a Portfolio Rule 3: The rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio. r p = W 1r 1 + W 2r 2 W1 = Proportion of funds in Security 1 W2 = Proportion of funds in Security 2 r1 = Expected return on Security 1 r2 = Expected return on Security 2 6-11 1-11 .

Portfolio Risk with Risk-Free Asset Rule 4: When a risky asset is combined with a risk-free asset. the portfolio standard deviation equals the risky asset’s standard deviation multiplied by the portfolio proportion invested in the risky asset. s p = wriskyasset  s riskyasset 6-12 1-12 .

are combined into a portfolio with portfolio weights w1 and w2. respectively. the portfolio variance is given by: sp2 = w12s12 + w22s22 + 2W1W2 Cov(r1r2) Cov(r1r2) = Covariance of returns for Security 1 and Security 2 6-13 1-13 .Portfolio Risk Rule 5: When two risky assets with variances s12 and s22. respectively.