chapter 6 - 6-1RISK AVERSION AND CAPITAL ALLOCATION TO...

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Unformatted text preview: 6-1RISK AVERSION AND CAPITAL ALLOCATION TO RISKY ASSETSCHAPTER 66-2Outline of the Chapter•Risk– Difference between speculation and gambling– Risk averse investors and utility functions– Indifference curve– Estimating risk aversion•Capital Allocation– Risky versus risk-free portfolios•Forming portfolios of a risky and a risk-free asset– Expected risk and return of the portfolio– CAL– Lending and borrowing•Risk tolerance and asset allocation– Finding optimal complete portfolio•Passive investment strategies6-3Risk and Risk Aversion• Constructing a portfolio is a two step process:1)Selecting the composition of risky assets; such as stocks and bonds2) Deciding how much to invest in that risky portfolio versus in a safe asset such as T-bills• In order to decide how much to invest in risky and risk-free assets the investor should know the risk and return trade-off.6-4Risk and Risk Aversion (Continued)•Risk is the concept that denotes the specific probabilities of specific events.– Can be negative or positive – In this concept risk is volatility of the return of the risky asset– Keep in mind that risk (negative) must be accompanied by a reward– Speculation versus gambling•Speculation– The assumption of considerable investment risk to obtain commensurate (corresponding, proportionate) gain6-5Risk and Risk Aversion (Continued)– Considerable risk: • Sufficient to affect the decision– Commensurate gain• A positive risk premium– (expected holding period return of a risky stock)-(risk-free rate)• An expected profit greater than the risk-free alternative•Gamble – Bet on an uncertain outcome– The difference is the lack of commensurate gain6-6Risk and Risk Aversion (Continued)•Whereas the gamble is the assumption of risk for no purpose but enjoyment of the risk itself, the speculation is undertaken in spite of the risk involved because one perceives a favorable risk-return trade-off.•In order to turn gamble into speculation the risk-averse investor has to be offered an adequate risk premium to bear the risk.•Risk averse investors are the ones who needs positive risk premiums on stocks in order to invest– Risk premium: the difference between the expected return on risky and risk-free assets•A risky investment with a risk premium of zero called a fair game– Fair game is usually rejected by the risk-averse investors6-7Risk and Risk Aversion (Continued)•Example (Concept check 1)– There is a US investor– The interest rates on UK and US T-Bills are same (5%)– The characteristics of these two securities are almost same (short-term, default –free assets)– Neither offers a risk premium– There is an exchange rate risk for the US investor since pounds earned on UK T-Bills will be exchanged for dollars in the future• Current exchange rate is $2 per pound– Is the US investor engaging in speculation or gambling?6-8Risk and Risk Aversion (Continued)•Risk Aversion and Utility Values– Risk averse investors reject investment portfolios...
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chapter 6 - 6-1RISK AVERSION AND CAPITAL ALLOCATION TO...

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