1.1.BKM Ch 06
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Risk-Free (rf) asset
- T-Bills are used as benchmark because:
- 1. free of default risk
- 2. short term nature makes it insensitive to interest rate risk
- 3. short term nature minimize exposure to inflation uncertainty
Expected return in XS of rf
Utility score of risky portfolio
- Used to quantify investor's risk aversion (determines if one risky prospect is better than another)
- U = E(r) - 0.5Aσ2
- where A = assumed risk aversion
Certainty equivalent rate of return
- Rate of return that would cause the investor to be indifferent between risky and rf investment.
- A portfolio is desirable only if its certainty ror > rf
Different types of investors
- Risk averse (A > 0): only considers inv w/ positive risk premium
- Risk neutral (A = 0): judges risks solely on E(r)
- Risk lover (A < 0): willing to engage in fair games and gambles
- A can be estimated by determining the price at which the investor is indifferent between buying insurance or bearing the risk.
Mean-variance (M-V) criterion
Portfolio A dominates B if E(rA) ≥ E(rB) and σA ≤ σB, with at least one strict inequality
Line that connects all portfolios with the same utility value
Utility maximization point
y* = [E(rP) - rf] / AσP2
Capital Allocation Line
- Line representing the different allocation possibilities between risky and rf assets
- Equation: E(rc) = rf + S * σCWhere S = [E(rP) - rf] / σP = Sharpe Ratio or Reward-to-Variability Ratio
Capital Market Line (CML)
Used when the risky index of the CAL is chosen as a broad index of common stocks (market proxy)
Describes a portfolio decision that avoids any direct or indirect security analysis.
Common criticism of the passive strategy
- Undiversified: 25% of index is invested in top 10 firms. However funds usually adopt similar weights
- Top-Heavy: 500 top firms = 77% of mkt
- Chasing Performance
- You Can Do Better: evidence shows it's rare & rdm
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