Lecture 4 - Lecture4:Outline Motivation:riskaversion

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Lecture 4: Outline • Motivation: risk aversion • Portfolio theory: mathematical preliminaries – Probability distributions – Expected value, variance, standard deviation – Multivariate probability distributions – Covariance, correlation – Portfolio expected return and risk
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Risk aversion: Deal or no deal? • Consider 2 options A and B: • A: Get $500,000 with certainty • B: Get $1M with probability 0.5      and $0 with probability 0.5 • Which do you prefer, A or B? • Most people prefer A. We say these people are risk  averse.
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Probability distributions • A  random variable , say r, can take on different values  r 1 , r 2 ,…, r in different states 1, 2,…, S Each state i has a probability p i  of occurring • Each probability is non-negative • Sum of all probabilities equals 1
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Expected return and standard deviation The expected return E( r ) or E[r] of an asset is the probability weighted average of all possible returns The variance of the return is the expected squared deviation of the return from its mean Standard deviation
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Lecture 4 - Lecture4:Outline Motivation:riskaversion

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