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3/25/08
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Risk Aversion
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There is a human distain for risk
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We will pay for no risk (ex. insurance)
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The more risky something is, the more compensation
higher stakes
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When potential payouts are large, need a lot of compensation because of
higher opportunity cost
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Every hotel has 2 cash flows: operations and real estate
Why is gambling so interesting in light of this conversation?
People gamble even though they know the odds are against them
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Risk + negative expected return
Why? Entertainment
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Investors are positive in risk aversion
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Risk goals
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Can we quantify risk?
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Can we price risk?
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Opportunity cost comes from probability of future payouts (uncertainty = risk)
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Breadth of choices
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Relative probability of each choice
Which measure can we use?
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Add up all possibilities, divide by number of possibilities
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Weighted average = expected value
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Variance = squared deviation from the average
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Square root of variance = standard deviation
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Variance captures range as well as value
Range = highest value – lowest value
Risk may be measured by variance
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What about portfolios? Bundles of stock?
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Do you have twice as much variance
twice as much risk?
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No, because of diversification
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If two stocks in a portfolio move together, you are no better off
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If they move opposite, you have no risk
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If they move together half of the time and opposite half, then the level of
risk is between zero and the same risk, but we are still reducing risk
3/27/08
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Diversification diminishes risk
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If stocks move in opposite direction, the correlation is always 1
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If stocks move in exactly the same direction, correlation = 1
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Correlation = 0 means that stocks move together half of the time
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If correlation = .5, first stock went up, it is more likely that the second stock went
up
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If you care only about diversification, you want correlation of 1
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TVM Market Assumption: perfect market
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No transaction costs
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If you are going to diversify at all, you should diversify as much as
possible
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As you add stocks at the beginning, drastic effect
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Near the end, not so effective
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Index Funds
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Most powerful: Dow Jones Industrial Average
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Most index funds have around 200 stocks
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Barclay’s
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Started index fund money
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Runs most index markets
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Created under umbrella of “ishare” products
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If your portfolio has a correlation of 1, it is impossible to reduce risk
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CAPM
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Capital Asset Pricing Model
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What it tells us: if the market is perfect, the opportunity cost is that
portfolio that is maximally diversified
“r”
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Therefore, it must include every stock
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Perfect 1 and 1 correlations are impossible in this model
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It doesn’t work in real life because there is no capital market portfolio
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thus, we can price risk
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We were trying to find how much risk & how much compensation per unit
of risk
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Rm (return of marketcapital market portfolio)
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This note was uploaded on 05/07/2008 for the course H ADM 222 taught by Professor Qma during the Spring '07 term at Cornell University (Engineering School).
 Spring '07
 QMA

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