# 1.1.BKM Ch 06

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1. 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
3. 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
4. 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
5. 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.
6. Mean-variance (M-V) criterion
Portfolio A dominates B if E(rA) ≥ E(rB) and σA ≤ σB, with at least one strict inequality
7. Indifference curve
Line that connects all portfolios with the same utility value
8. Utility maximization point
y* = [E(rP) - rf] / AσP2
9. Capital Allocation Line
• Line representing the different allocation possibilities between risky and rf assets
• Equation: E(rc) = rf + S * σC
• Where S = [E(rP) - rf] / σP = Sharpe Ratio or Reward-to-Variability Ratio
10. Capital Market Line (CML)
Used when the risky index of the CAL is chosen as a broad index of common stocks (market proxy)
11. Passive strategy
Describes a portfolio decision that avoids any direct or indirect security analysis.
12. 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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 Author: Exam9 ID: 58321 Filename: 1.1.BKM Ch 06 Updated: 2011-02-08 02:35:54 Tags: BKM Folders: Description: BKM Chap 09 Show Answers:

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