Lecture Investments (Special Indian Edition): Chapter 6 - Bodie, Kane, Marcus

In this chapter, we begin by introducing two themes in portfolio theory that are centered on risk. The first is the tenet that investors will avoid risk unless they can anticipate a reward for engaging in risky investments. The second theme allows us to quantify investors’ personal trade-offs between portfolio risk and expected return. | Chapter 6 Risk and Risk Aversion W = 100 W1 = 150 Profit = 50 W2 = 80 Profit = -20 p = .6 1-p = .4 E(W) = pW1 + (1-p)W2 = 6 (150) + .4(80) = 122 s2 = p[W1 - E(W)]2 + (1-p) [W2 - E(W)]2 = .6 (150-122)2 + .4(80=122)2 = 1,176,000 s = Risk - Uncertain Outcomes W1 = 150 Profit = 50 W2 = 80 Profit = -20 p = .6 1-p = .4 100 Risky Inv. Risk Free T-bills Profit = 5 Risk Premium = 17 Risky Investments with Risk-Free 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 Risk Aversion & Utility Risk Aversion and Value: U = E ( r ) - .005 A s 2 = .22 - .005 A (34%) 2 Risk Aversion A Value High 5 3 Low 1 T-bill = 5% Dominance Principle 1 2 3 4 Expected Return Variance or Standard Deviation • 2 dominates 1; has a higher return • 2 dominates 3; has a lower risk • 4 dominates 3; has a higher return Utility and Indifference Curves Represent an investor’s willingness to trade-off return and risk. Example Exp Ret St Deviation U=E ( r ) - .005As2 10 2 15 2 20 2 25 2 Indifference Curves Expected Return Standard Deviation Increasing Utility Expected Return Rule 1 : The return for an asset is the probability weighted average return in all scenarios. Variance of Return Rule 2: The variance of an asset’s return is the expected value of the squared deviations from the expected return. 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, with the portfolio proportions as weights. rp = W1r1 + W2r2 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 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. Rule 5: When two risky assets with variances s12 and s22, respectively, are combined into a portfolio with portfolio weights w1 and w2, respectively, the portfolio variance is given by: p2 = w12 12 + w22 22 + 2W1W2 Cov(r1r2) Cov(r1r2) = Covariance of returns for Security 1 and Security 2 Portfolio Risk | Chapter 6 Risk and Risk Aversion W = 100 W1 = 150 Profit = 50 W2 = 80 Profit = -20 p = .6 1-p = .4 E(W) = pW1 + (1-p)W2 = 6 (150) + .4(80) = 122 s2 = p[W1 - E(W)]2 + (1-p) [W2 - E(W)]2 = .6 (150-122)2 + .4(80=122)2 = 1,176,000 s = Risk - Uncertain Outcomes W1 = 150 Profit = 50 W2 = 80 Profit = -20 p = .6 1-p = .4 100 Risky Inv. Risk Free T-bills Profit = 5 Risk Premium = 17 Risky Investments with Risk-Free 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 Risk Aversion & Utility Risk Aversion and Value: U = E ( r ) - .005 A s 2 = .22 - .005 A (34%) 2 Risk Aversion A Value High 5 3 Low 1 T-bill = 5% Dominance Principle 1 2 3 4 Expected Return Variance or Standard Deviation • 2 dominates 1; has a higher return • 2 dominates 3; has a lower risk • 4 dominates 3; has a higher return Utility and Indifference Curves Represent an investor’s willingness to trade-off .

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