Risk Penalty Models

3 basic principles of portfolio theory

Principle 1: Investors avoid risk therefore they must be compensated for taking on that risk → Risk Premium

Principle 2: Investors have different risk preferences, you have to look at utility to determine a persons set risk and expected return

Principle 3: You can't look at an investment's risk by itself, you need to look at how it compares to the entire portfolio

What is a Risk Penalty Model?

A mean-variance model describing how investors penalize return based on the risk of the investment

What is the Risk Penalty Model Formula

U = E(Ri) - 1/2Ao² Expected Return - Risk Penalty

When is risk present?

Risk is present whenever more than one outcome is possible. Whenever the observed return is different from expected return.

TF always choose the investment with the highest utility

True

A>0

More Risk Averse

What does the utility curve show?

The combos of risk and return that give the same utility

if you take on more risk you need more expected what?

You need more expected return to keep the same utility