Improved Chaper 6 Content: Capital Allocation to Risky Assets

Speculation

Anyone who is taking on risk in order to obtain a return proportional to the risk undertaken.

Fair Game

investment which has no risk premium

Gamble

An investment with an uncertain outcome.

The risk is assumed for enjoyment of the risk itself.

Risk Averse Person

A person no interested in an uncertain payoff.

They will prefer having safety.

Utility Function

U = Expected Return of the Asset - 1/2*(Index of investor risk aversion) *(Variance of the portfolio)

Utility = Expected Return minus a penalty for risk, and the penalty is personal.

Index of Investor Risk Aversion is determined by?

A survey

Risk Premium

Expected Return - Risk Free Rate

Risk Neutral (A=0)

Risk neither excites nor causes fear

Mean-Variance Criterion

The selection of portfolios based on the means and variances of their returns.

"** For us to like a portfolio better than another, we expect returns to be greater, and variance to be lower**

Indifference Curve

All the portfolios in the curve are indifferent to the investor since they provide the same utility. It has portfolios with different combinations of return and risks, but they provide the same utility.

Capital Allocation Question

How much weight are we going to put to our risky assets, and how much weight goes to our risky free assets.

We don’t care about the development of the assets.

This depends on our level or risk aversion.

Risk Free Asset

Has a guaranteed rate of return. We are going to use t-bills as our risk free asset.