W5 Principles of Finance

Arithmetic Average

Average return earned from single one- period investment over specific time horizon

Geometric Average

Average return earned per period from an investment over an investor's entire time horizon

Observed (Realised) Risk of Security

Measured by variability in its realised returns around arithmetic average return

Fisher Effect

(Link between the returns)

Expected Return

Expected outcome • Do expected value formula but probability is the return % • Same with Variance

Normal Distribution

• Requires expected return & standard deviation • Symmetric around mean • Implies unlimited downside loss (very small chance could lose $10000+)

Attitude Towards Risk

1. Risk Aversion 2. Risk Neutral 3. Risk Seeking

1. Risk Aversion

Investors demand compensation (Higher E®) for higher risk (How much compensation depends on risk appetite) a. Objective

2. Risk Neutral

Investors don't take into account risk when deciding asset to invest in

3. Risk Seeking

Investors gain utility from risk, they will be willing to give uo some E® to take more risk

Covariance of Returns

Measures level of co-movement between security returns

1. Postive Co

Assets move together

2. Negative CoV

1 asset does well other does not

3. Cov = 0

Move independently (knowing what happens to 1 security tells us nothing of security 2)

Correlation of Returns

Standardized measure of co-movement between 2 securities

Risk-return Tradeoff

Depends on co-movement between returns

Diversification Benefit

Driven by relationship between return of 2 assets