Term 1 Flashcards

1
Q

What should an adverse utility function look like?

A

U’(W)>0
U’‘(W)<0
DMR

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2
Q

What is the expected Wealth, U(E(W) CE and (U(W)?

A

E(W)= XP
U(E(W))=f(X
P)
E(U(W))=f(x)*P
CE=E(U(W)) inversed

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3
Q

What are the attitudes to risk?

A

Averse: U(E(W)>E(U(W))
Neutral: U(E(W)=E(U(W))
Loving: U(E(W)

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4
Q

What are the Arrow Pratt measures of risk aversion?

A
ARA = -U''(W)/U'(W)
RAR= -WU''(W)/U'(W)
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5
Q

How can you calculate the risk premium using Arrow Pratt?

A

0.5 * Var * -U’‘(W)/U’(W)

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6
Q

What is First Order Stochastic Dominance?

A

If the CDF is always less for one function, it dominates

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7
Q

What is Second Order Stochastic Dominance?

A

If the Sum of the difference of the CDF is always positve, the second term dominates

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8
Q

What are the decisions for Mean Variance Criteria?

A

If same mean, lower var is better
If same Var, higher mean is better
Highest IC

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9
Q

What s the Mean Variance Paradox?

A

If the assets are not normally distributed, you may choose an asset even though it stochastically dominates

Remedy: Use SD

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10
Q

Descibe a payoff matrix?

A

A row descibes the payoff of an asset

A collumn descibes a given state

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11
Q

Define linear dependance?

A

Assets are linearly dependant if you can make one using the others

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12
Q

Define a complete capital market?

A

If the assets in the market are linearly independent, market is complete
Matrix has non zero determinant

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13
Q

Discuss Arbitrage?

A

All assets with the same payoffs should cost the same

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14
Q

What is a pure security and how does it apply?

A

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

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15
Q

What is the price of a risk free asset?

A

1/1+rf

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16
Q

How can you create a risk free asset?

A

Sum all pure securities

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17
Q

What is the price of a pure security?

A

P=Pis*0s
Pis is probability
Theta is price in a state thus

Pis X 1/1+E(rs)

18
Q

How does wealth, return and theta vary based on the state?

A

In the lowest state, wealth is low, thus expected return is low, thus price is higher

19
Q

Decompose the price of a pure Security?

A

P={1/1+rf} X Pi X [1- (ER-Rf/1+ER)]

20
Q

How do you calculate the NPV of an asset?

A

Calculate pure security prices

Multiply pure security prices by payoff

21
Q

How do you calculate the variance in a two asset portfolio?

A

a^2Varx+b^2VarY+2abRSDxSDY

22
Q

How do you calculate the minimum variance portfolio?

A

Differentiate the variance with respect to a

a*=VarY-RSDxSDY / VarX+VarY-2RSDxSDY

23
Q

Discuss perfectly correlated assets?

A

SDP=aSDx+BSDy

Straight line, to right of X short sell Y, same for Y

24
Q

Discuss negative perfect correlation

A

SDP=aSDx+B(-SDy)

V shape, to right of either point, short sell other

25
Q

What is the efficent set?

A

The top half of an opportunity set

26
Q

What happens if we include a risk free asset?

A

The optimum portfolio lies on a line tangental to the asset

27
Q

Describe the major points on the market portfolio?

A

Rf is all risk free
M is all risky
Beyond is short risky

28
Q

What is the equation for the CML?

A

Rf+(Erm-Rf/SDM)SdP

29
Q

What are the assumptions of the CAPM?

A

Homogeneous expectations
No taxes / transaction costs
Only mean and variance matter

30
Q

How do you derive the CAPM?

A

Differentiate ER and Var with respect to a
Set a = 0
Divide ER/Var
Rearrange for ER

31
Q

What is the CAPM equation?

A

ER=Rf+(ERm-RF)(Covi,m)/Varm

32
Q

What is the two step testing procedure for the CAPM?

A

Use R-Rft=(Rm-Rf)B+e to calculate Betas for all stocks

Use R-Rf=y+y1B+e
Y should be statistically insignificant
Y1 should be equal to Rm-Rf

33
Q

What are the empirical results of the CAPM?

A

Yo is significant

Y1 is greater that suspected

34
Q

What is the roll critique?

A

Cannot find market portfolio therefore un testable

35
Q

What are the assumptions of the arbitrage pricing theory?

A

All returns are described by the model

No unsystematic risk

36
Q

What are the disadvantages of the APT?

A

Does not say what factors to include?

37
Q

What are Roll and Ross 1986 factors?

A

Industrial production
Inflation
Quality Spread - Difference in returns of long and short corporate bonds
Term Spreads - Gov Bonds

38
Q

What is the FF three factor model?

A

Considers book value and market cap?

39
Q

How do you calculate SMB and HML?

A

SMB =Small Cap Stocks - Large Cap Stocks

HML = High Book - Low Book

40
Q

What are the 3 layers of the EMH?

A

Weak form- All past information
Semi-Strong - All current
Strong - Insider Information

41
Q

What is the joint hypothesis problem?

A

You do not know whether the EMH is wrong or you are classifying normal returns

42
Q

What should not be present in markets if weak form efficiency is true?

A

Serial Correlation