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Fina 385: Theory of Finance 1 > stuff from lesson 2 (week 1) > Flashcards

stuff from lesson 2 (week 1) Flashcards

1
Q

speculation

A

the assumption of considerable business risk in obtaining commensurate gain

–> this definition is useless without first specifying what is meant by “commensurate gain” and “considerable risk”

undertaken because one perceives a favorable risk–return tradeoff

taking a risk with the expectation of being compensated for it by appropriate returns

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2
Q

commensurate gain

A

a positive expected profit beyond the risk-free alternative

–> the risk premium, the incremental expected gain from taking on the risk

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3
Q

considerable risk

A

the risk is sufficient to affect the decision

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4
Q

the central difference between gambling and speculation

A

the lack of “commensurate gain”

Personal expectations

–> Expected payoff could be zero in gambling

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5
Q

a gamble

A

the assumption of risk for enjoyment of the risk itself

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6
Q

how do we turn a gamble into a speculative prospect?

A

we need an adequate risk premium for compensation to risk-averse investors for the risks that they bear

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7
Q

heterogeneous expectations

A

individuals perceiving different probabilities for the same scenarios

–> investors on each side of a financial position see themselves as speculating rather than gambling

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8
Q

The ideal way to resolve heterogeneous expectations

A

to merge the information

for each party to verify that he or she possesses all relevant information and processes the information properly

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9
Q

a fair game

A

A prospect that has a zero-risk premium

–> rejected by risk averse investors

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10
Q

risk averse investors

A

consider only risk-free or speculative prospects with positive risk premiums

reject fair games or worse

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11
Q

utility

A

a welfare score to competing investment portfolios based on the expected return and risk of those portfolios

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12
Q

The utility value

A

may be viewed as a means of ranking portfolios

–> Higher utility values are assigned to portfolios with more attractive risk–return profiles

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13
Q

formula for utility

A

U = ER - 1/2A · σ^2

U: the utility value

A: an index of the investor’s aversion to taking on risk

–> The extent to which variance lowers utility depends on A, the investor’s degree of risk aversion

–> More risk-averse investors (who have the larger A’s) penalize risky investments more severely

the formula is consistent with the notion that utility is enhanced by high expected returns and diminished by high risk

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14
Q

the utility provided by a risk-free portfolio

A

simply the rate of return on the portfolio, since there is no penalization for risk

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15
Q

The certainty equivalent rate of a portfolio

A

the rate that risk-free investments would need to offer with certainty to be considered equally attractive to the risky portfolio

The utility generated by the risky portfolio equal to the utility generated by the risk free investment

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16
Q

risk-neutral investors

A

judge risky prospects solely by their expected rates of return

The level of risk is irrelevant to the risk-neutral investor, meaning that there is no penalization for risk

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17
Q

what is the certainty equivalent rate of a portfolio for a risk-neutral investor?

A

simply the portfolio’s expected rate of return

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18
Q

A risk lover

A

willing to engage in fair games and gambles

–> will take a fair game because their upward adjustment of utility for risk gives the fair game a certainty equivalent that exceeds the alternative of the risk-free investment

this investor adjusts the expected return upward to take into account the “fun” of confronting the prospect’s risk

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19
Q

the indifference curve

A

the curve in the graph and shit

20
Q

the types of risk that can affect a company’s economic performances and our portfolios

A

systematic risk (market risk)

company specific risk

21
Q

diversification

A

not putting all the eggs in one basket

we include additional securities in your risky portfolio to spread out our exposure to firm-specific factors (company specific risk)

–> portfolio volatility (risk) should continue to fall

22
Q

why can’t diversification eliminate all risk?

A

because virtually all securities are affected by the common macroeconomic factors (systematic risk)

23
Q

the insurance principle

A

the reduction of risk to very low levels in the case of independent risk because belief that an insurance company depends on the risk reduction achieved through diversification when it writes many policies insuring against many independent sources of risk

24
Q

systematic risk (market risk)

A

The risk that remains even after extensive diversification

affects all firms and is inevitable

nondiversifiable risk

25
Q

the two tasks of portfolio construction

A

Allocation of overall portfolio to safe assets or risky assets

determination of composition of the risky portion of the portfolio

26
Q

Portfolio theory starts with what?

A

with the capital allocation decision

27
Q

Choosing the amount of money you need to allocate to a risky portfolio is a personal decision that depends mainly on what?

A

one one’s attitude towards risk

28
Q

Rational investors

A

avoid investing in a risky asset unless they are compensated for the risk they are taking by additional expected return

invest in risky assets only if they anticipate higher returns that is commensurate to the risk they are accepting

29
Q

Heterogeneous expectations

A

based on information and all investors should have access to

30
Q

one’s utility value depends on what?

A

Risk (measured by volatility)

Reward or compensation (measured by expected returns)

Personal preference (measured by Risk Aversion Coefficient)

31
Q

In selecting risky portfolios, investors choose the investment that delivers the highest or lowest utility?

A

the highest utility

32
Q

the value of A for risk neutral investors

A

0

33
Q

the value of A for risk loving investors

A

<0

34
Q

the value of A for risk averse investors

A

> 0

35
Q

if an investor, either risk neutral, loving, or averse, is indifferent between two alternative investments, what does it mean for the utilities generated by the two investments?

A

the utilities generated by these two investments are equal

36
Q

in practice, which assets are considered good proxies for Risk Free rate? why?

A

short Term Treasury Bills

They are issued by the government making them default free

Their short term nature (less than a year) makes them immune to
fluctuations in interest rates and particularly the inflation factor

37
Q

CAL – Capital Allocation Line

A

The capital allocation line (CAL) makes up the allotment of risk-free assets and risky portfolio for an investor

a line created on a graph of all possible combinations of risk-free and risky assets

the graph displays the return investors might possibly earn by assuming a certain level of risk with their investment

38
Q

CML

A

a line created on a graph of all possible combinations of risk-free and risky assets

the graph displays the return investors might possibly earn by assuming a certain level of risk with their investment

is a special case of the CAL where the risk portfolio is the market portfolio

39
Q

CAL – Capital Allocation Line formula

A

ERc = RF + y · (ERp - RF)

y being the allocation of the risky asset

ERc = RF + σc · (ERp - RF)/σp

The above equation states that investors expect a return on their complete risky portfolio that is higher than the Risk Free Rate (RF) by an amount equal to y

40
Q

when does the CAL become the CML?

A

when our risky portfolio “P” happens to be the Market Portfolio (M)

the formula stays the same

41
Q

the link between y and our utility

A

we have to choose a value of y, so the proper allocation of our risky asset, which will increase our utility

42
Q

using indifference curves, which is the optimal portfolio?

A

the one in which one of the indifference curves is tangent to either the CAL or CML

43
Q

what is the value of A in indifference curves?

A

A is the slope

A is fixed per investor

44
Q

risk averse have steep or flatter indifference curves? why?

A

steeper curves because they require more return to compensate for more risk

45
Q

Portfolio construction

A

Allocation of overall portfolio to safe assets or risky assets

Determination of composition of the risky portion of the portfolio

46
Q

Portfolio theory

A

starts with the capital allocation decision

47
Q

Choosing the amount of money you need to allocate to a risky portfolio is a personal decision that depends mainly on what?

A

attitude towards risk

Fina 385: Theory of Finance 1 (12 decks)

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