Term 1 Flashcards
What should an adverse utility function look like?
U’(W)>0
U’‘(W)<0
DMR
What is the expected Wealth, U(E(W) CE and (U(W)?
E(W)= XP
U(E(W))=f(XP)
E(U(W))=f(x)*P
CE=E(U(W)) inversed
What are the attitudes to risk?
Averse: U(E(W)>E(U(W))
Neutral: U(E(W)=E(U(W))
Loving: U(E(W)
What are the Arrow Pratt measures of risk aversion?
ARA = -U''(W)/U'(W) RAR= -WU''(W)/U'(W)
How can you calculate the risk premium using Arrow Pratt?
0.5 * Var * -U’‘(W)/U’(W)
What is First Order Stochastic Dominance?
If the CDF is always less for one function, it dominates
What is Second Order Stochastic Dominance?
If the Sum of the difference of the CDF is always positve, the second term dominates
What are the decisions for Mean Variance Criteria?
If same mean, lower var is better
If same Var, higher mean is better
Highest IC
What s the Mean Variance Paradox?
If the assets are not normally distributed, you may choose an asset even though it stochastically dominates
Remedy: Use SD
Descibe a payoff matrix?
A row descibes the payoff of an asset
A collumn descibes a given state
Define linear dependance?
Assets are linearly dependant if you can make one using the others
Define a complete capital market?
If the assets in the market are linearly independent, market is complete
Matrix has non zero determinant
Discuss Arbitrage?
All assets with the same payoffs should cost the same
What is a pure security and how does it apply?
A ficticious asset that pays 1 in a state and zero in others
If you replicate an asset with a portfolio of pure securities, they should have the same price
What is the price of a risk free asset?
1/1+rf
How can you create a risk free asset?
Sum all pure securities