Topics 1 & 2- Return, Risk and Risk Aversion Flashcards Preview

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Flashcards in Topics 1 & 2- Return, Risk and Risk Aversion Deck (15)
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What is a simple prospect?

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


What does the geometric mean consider?

- considers the principle of
compounding, and we assume that dividend are reinvested


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

- Arithmetic mean is always greater than or equal to.


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.


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.


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

rules 1&2 becomes:
 Arithmetic Mean Return
 S.D.


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.


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.


What is rule 5 of portfolio math?

Rule 5: When two risky assets with variances
2 and 2
2, respectively, are combined into a
portfolio with portfolio weights w1 and w2,
respectively, the portfolio variance is given
2 = w1
2 + w2
2 + 2W1W2 Cov(r1r2)
Cov(r1r2) = Covariance of returns for
Security 1 and Security 2


A more positive covariance does what to portfolio variance?

- It increases portfolio variance


A more negative covariance does what to portfolio variance?

- It decreases portfolio variance


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)


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)


What is utility?

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


What is a risk seeker?

- Investor that loves risk

- Risk lovers adjust the expected return upward to take into account the ‘fun’ of taking risk (risk becomes positive effect; A<0)