L5 - Risk and Expected Return Flashcards
1
Q
What are the two main financial axioms related to risk and return?
A
- Recall two of the Finance Axioms:
- – Investors prefer more to less
- – Investors are risk-averse
- ■ This means that:
- – Investors prefer an investment with a higher expected return E(Ri ) – Investors prefer an investment with a lower variance and standard deviation, s.di
- ■ Investors must optimally tradeoff risk and return in order to maximize their expected utility
2
Q
When does the EAR equal the APR?
A
- When the rate is compounded annually
- After which the EAR increases with the frequency of the compounded interest
3
Q
When do we use EAR and APR when taking about returns?
A
- Depends on how the gains are invested
- EAR –> when the gains are allowed to be reinvested
- APR –> when money is put in a zero interest-bearing checking account (gains are put aside each period)
4
Q
How can we score Expected Utility?
A
- By using the moments of the data
- U = E(R) - 0.5(A)*σ2
- Where A determines the risk-aversion of the investor
- A > 0 –> risk aversion –> positive utility curve
- A = risk natural –> flat utility curve
- A < 0 –> risk-seeking –> negative utility curve?
5
Q
Who came up with the theory of Rational investors?
A
- Rational investors and expected utility theory
- Four axioms
- – Completeness: For two lotteries A, and B. Investors either prefer A over B, B over A, or are indifferent.
- – Transitivity: For three lotteries A, B, and C. If an investor prefers A over B and B over C, then the investor prefers A over C. –
- Convexity: For three lotteries A, B, and C. If the investor prefers A over B, and B over C, then there is a linear combination of A and C such that the investor is indifferent between B and this combination w*A+(1-w)*C for weight w.
- – Independence: For three lotteries A, B, and C. If A is prefered over B, then a combination of A and C is prefered over the same combination of B and C.
