Class Notes - Prelim 2

# Class Notes - Prelim 2 - Risk Aversion o There is a human...

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3/25/08 Risk Aversion o There is a human distain for risk o We will pay for no risk (ex. insurance) o The more risky something is, the more compensation higher stakes o When potential payouts are large, need a lot of compensation because of higher opportunity cost o 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 Risk + negative expected return Why? Entertainment o Investors are positive in risk aversion Risk goals o Can we quantify risk? o Can we price risk? Opportunity cost comes from probability of future payouts (uncertainty = risk) o Breadth of choices o Relative probability of each choice Which measure can we use? Add up all possibilities, divide by number of possibilities Weighted average = expected value Variance = squared deviation from the average Square root of variance = standard deviation o Variance captures range as well as value Range = highest value – lowest value Risk may be measured by variance What about portfolios? Bundles of stock? o Do you have twice as much variance twice as much risk? o No, because of diversification o If two stocks in a portfolio move together, you are no better off o If they move opposite, you have no risk o 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 Diversification diminishes risk If stocks move in opposite direction, the correlation is always -1 If stocks move in exactly the same direction, correlation = 1 Correlation = 0 means that stocks move together half of the time If correlation = .5, first stock went up, it is more likely that the second stock went up If you care only about diversification, you want correlation of -1 TVM Market Assumption: perfect market o No transaction costs

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o If you are going to diversify at all, you should diversify as much as possible o As you add stocks at the beginning, drastic effect o Near the end, not so effective Index Funds o Most powerful: Dow Jones Industrial Average o Another powerful one: S&P 500 o Most index funds have around 200 stocks Barclay’s o Started index fund money o Runs most index markets o Created under umbrella of “ishare” products If your portfolio has a correlation of 1, it is impossible to reduce risk CAPM o Capital Asset Pricing Model o What it tells us: if the market is perfect, the opportunity cost is that portfolio that is maximally diversified “r” o Therefore, it must include every stock o Perfect 1 and -1 correlations are impossible in this model o It doesn’t work in real life because there is no capital market portfolio o thus, we can price risk o We were trying to find how much risk & how much compensation per unit of risk o Rm (return of market---capital market portfolio) o Rf (risk-free return—i.e. US treasury) o
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