Flashcards in Topics 1 & 2- Return, Risk and Risk Aversion Deck (15)

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1

## What is a simple prospect?

### - A simple prospect is an investment opportunity with a certain initial wealth and two possible outcomes

2

## What does the geometric mean consider?

###
- considers the principle of

compounding, and we assume that dividend are reinvested

3

## Which is always bigger than or equal to, the arithmetic mean or geometric mean?

### - Arithmetic mean is always greater than or equal to.

4

## What is rule 1 of portfolio math?

### Rule 1 : The mean or expected return for an asset is the probability weighted average of its return in all scenarios.

5

## What is rule 2 of portfolio math?

###
Rule 2: The variance of an asset’s return is the expected value of the squared deviations from the expected return.

6

## What happens to rules 1 & 2 when assume the probability is equal?

###
rules 1&2 becomes:

Arithmetic Mean Return

S.D.

7

## What is rule 3 of portfolio math?

### Rule 3: The rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with the portfolio proportions as weights.

8

## What is rule 4 of portfolio math?

### Rule 4: When a risky asset is combined with a risk-free asset, the portfolio standard deviation equals the risky asset’s standard deviation multiplied by the portfolio proportion invested in the risky asset.

9

## What is rule 5 of portfolio math?

###
Rule 5: When two risky assets with variances

1

2 and 2

2, respectively, are combined into a

portfolio with portfolio weights w1 and w2,

respectively, the portfolio variance is given

by:

p

2 = w1

21

2 + w2

22

2 + 2W1W2 Cov(r1r2)

Cov(r1r2) = Covariance of returns for

Security 1 and Security 2

10

## A more positive covariance does what to portfolio variance?

### - It increases portfolio variance

11

## A more negative covariance does what to portfolio variance?

### - It decreases portfolio variance

12

## What is a risk averse investor?

###
- only consider risk free or

speculative prospects with positive risk premium

- only accept investments

with positive risk premium (considering both return and risk; A>0)

13

## What is a risk neutral investor?

###
- Don't care about risk

- judge risky prospects solely by their expected rate of return (considering return only; A=0)

14

## What is utility?

### - Its a score to rank investment portfolios based on the expected return and risk of portfolios

15