Flashcards in BKM Chapter 6 Deck (26)
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1
Speculation
(BKM - 6)
assumption of considerable investment risk to obtain commensurate gain
2
Risk premium (aka excess return)
(BKM - 6)
excess returns = expected return - risk-free rate
3
Gamble
(BKM - 6)
bet or wager on an uncertain outcome
(aka a fair game)
4
Key difference between a speculation and a gamble
(BKM - 6)
a gamble is undertaken for the enjoyment of risk
speculation is undertaken in spite of risk because of a perceived favorable risk-return tradeoff
5
Utility score
(BKM - 6)
U = E[r] - .5 * A * sigma^2
A = risk aversion index
6
Risk aversion index
(BKM - 6)
quantification of an investor's risk preferences
high A = more risk-averse
7
Variance of risk-free portfolios
(BKM - 6)
variance = 0
(utility = expected return)
8
Risk aversion index for risk-averse, risk-lovers, and risk-neutral investors
(BKM - 6)
risk-averse: A > 0
risk-neutral: A = 0
risk-lover: A < 0 (does not reject fair games/gambles)
9
Indifference curves
(BKM - 6)
plot expected returns against risk (x-axis)
all points on the curve represent portfolios with the same utility score (e.g. investor is indifferent between them)
10
Mean-variance criterion
(BKM - 6)
one portfolio dominates another if:
- it has the same/better expected return AND
- it has the same/lower risk/volatility
(with one inequality being strict)
11
Relationship between the risk aversion index (A) and indifference curves
(BKM - 6)
more risk-averse investors (higher A) will have a steeper indifference curve (b/c they require a greater increase in return for an increase in risk)
12
Capital allocation decision
(BKM - 6)
split of investments between risky and risk-free portfolios
13
Expected return of the complete portfolio
E[r-sub C]
(BKM - 6)
E[r-sub C] = y * expected return for the risky portfolio + (1 - y) * risk-free rate
y = % invested in the risky portfolio
Alternative:
E[r-sub C] = risk-free rate + sharpe ratio * std. deviation of the complete portfolio
14
Standard deviation of the complete portfolio
sigma-C
(BKM - 6)
sigma-C = y * sigma-P
(b/c the std. dev. of the risk-free portfolio is 0)
sigma-P = std. dev. of the risky portfolio
15
Simplest way to reduce risk
(BKM - 6)
shift funds away from the risky asset to the risk-free asset
16
Capital allocation line (CAL)
(BKM - 6)
linear combination of all risk-return combinations available to investors with varying proportions y invested in the risky asset
plots expected return against risk (x-axis)
17
Sharpe ratio (S, aka reward-to-volatility ratio) & interpretation
(BKM - 6)
S = expected excess return / standard deviation
interpretation: average % excess return for every 1% increase in standard deviation
18
A borrowing or levered position
(BKM - 6)
a short position where y > 1
in this case, y = total funds available / initial investment budget and the amount invested in the risk-free portfolio is still = 1 - y
generally will have higher risk
19
CAL with borrowing
(BKM - 6)
line will be "kinked" at point p (y = 1) because investors usually cannot borrow at the risk-free rate
(to determine the slope, replace the risk-free rate with the borrowing rate)
20
Optimal risky position (y*)
(BKM - 6)
the proportion invested in the risky asset that maximizes utility (U)
graphically: point on the highest possible indifference curve that is tangential to the CAL
21
Factors that determine the optimal risky position (2)
(BKM - 6)
1. risk aversion (A) - impacts the slope of the indifference curve
2. Sharpe ratio (S) - impacts the slope of the CAL (opportunity set)
22
Reasonability of standard deviation as a measure of risk
(BKM - 6)
only appropriate with normality
use VaR or expected shortfall with non-normality
23
Capital market line (CML)
(BKM - 6)
a CAL using 1-month T-bills as the risk-free portfolio and a well-diversified portfolio of common stocks that represents the risky portfolio
also = the opportunity set represented by a passive strategy
24
Passive strategy
(BKM - 6)
a portfolio decision avoiding direct or indirect security analysis
25
Reasons to pursue a passive strategy (2)
(BKM - 6)
1. passive strategies are less expensive than active strategies (both time & cost of information/market knowledge)
2. free-rider benefit: with many active knowledgeable investors most assets in the market will be fairly priced (because investors buy and drive up the price of underpriced stocks and sell/drive down the price of overpriced stocks)
26
