Lecture 5

Question 1

What is the discount rate in asset prices

Answer 1

Risk free rate or rate of return

Question 2

What is the probability distribution

Answer 2

Set of all possible values of a random variable and probability associated with each possible outcome

Question 3

What are the rules of probability distribution

Answer 3

1. Each outcome is assigned a probability
2. Each probability is non negative
3. Probabilities must sum to 1

Question 4

What is the best guess for future retune

Answer 4

Expected return

Question 5

What is expected return

Answer 5

Probability weighted average return of all possible outcomes

Question 6

How to properly measure risk

Answer 6

Look at how much the value of the stock varies

Question 7

What it is the variance

Answer 7

Expected value of the squared deviation from the mean

Question 8

What is standard deviation

Answer 8

How far returns are from expected value

Question 9

What is volatility

Answer 9

Standard deviation

Question 10

How do you compute historical returns

Answer 10

Counting the number of times a realized return falls within a particular range

Question 11

What is empirical distribution

Answer 11

When the probability distribution is plotted using historical data

Question 12

What happens when inflation rate increases?

Answer 12

Investors demand higher nominal rates of return

Question 13

What are tax liabilities based on?

Answer 13

Nominal income

Question 14

What are examples of negative and positive skewed assets?

Answer 14

Bonds and loans

Question 15

Would investors prefer positive or negative skews?

Answer 15

Negative

Question 16

What are examples of fat tailed distributed assets?

Answer 16

All financial assets

Question 17

What if excess returns are not normally distributed at value at risk

Answer 17

VaR is the quantile of distribution below which lies q % of the possible values of that distribution

Question 18

What does the VAR provide

Answer 18

A threshold for the losses at a given percentile

Question 19

What do the expected shortfall provide

Answer 19

Expected loss when the losses exceed the VaR threshold value

Question 20

What are some caveats

Answer 20

1. Return appear normally distributed
2. SD goes down over long time periods

Question 21

What does the utility model give

Answer 21

Optimal Allocation between risky portfolio and risk free asset

Question 22

What is diminishing marginal utility

Answer 22

Utility of expectation is higher than expected utility, they prefer certain payoffs to uncertain pay off

Question 23

What are risk premiums

Answer 23

Expected additional return for making a risky investment rather than a safe one

Question 24

Why do we need risk premiums

Answer 24

Investors are risk averse and demand for extra compensation for investing in assets with risky payoffs

Question 25

What happens if there is no risk premiums

Answer 25

Risk averse investors will invest in risk free assets

Question 26

What are the assumptions for investors

Answer 26

Investors like returns and dislike risk

Question 27

What do indifference curves describe

Answer 27

Describes different combinations of return and risk that provide equal utility

Question 28

What does it mean when there's a steeper curve

Answer 28

More risk averse

Question 29

Why are indifference curve curvilinear

Answer 29

Exhibits diminishing marginal utility of wealth

Question 30

How do investors choose a preferred portfolio

Answer 30

Estimate expected returns with investor preferences to find optimal asset allocation

Question 31

What is the capital allocation line (CAL)

Answer 31

Depicts investment opportunity and shows all risk return combination available to investors

Question 32

What will investors choose based on the CAL

Answer 32

Choose the highest indifference curve given the investment opportunity set

Question 33

What is the Sharpe ratio

Answer 33

Slope of the CAL and it is the ratio of excess return of the risky asset to its SD

Question 34

What does the Sharpe ratio tell us

Answer 34

How much extra return per unit of risk since this is a risk adjusted measure that quantifies the risk return trade off

Question 35

What are the rules of optimal allocation

Answer 35

Increase weight on the risky asset, utility increases and then declines (Curve) Optimal weight = maximize utility