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Outline-4 - Ec 173AFINANCIAL MARKETS LECTURE OUTLINE...

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Unformatted text preview: Ec 173AFINANCIAL MARKETS LECTURE OUTLINE Foster, UCSD October 21, 2010 TOPIC 4 RISK & RETURN A. Risk Factors in Interest Rates 1. Interest Compounding and Growth: [Review from Topic 2] 2. Building an Interest Rate: a) One year loan example. b) Generalization. 3. A More Complete Interest Rate Breakdown: a) Lets rewrite our linear approximation as r = r p + IP + RP. b) Real interest rate r r = r IP = r p + RP. c) Default risk premium (DP) d) Liquidity premium (LP). e) Maturity or interest-rate risk premium (MP). f) Risk-free rate r f = r RP = r p + IP. B. Asset Risk and Rates of Return 1. Rates of Return: a) Holding period return. b) Annual rate of return . c) Examples. 2. Risk: a) Risk defined. b) The rate of return is a random variable. c) Defining an asset's true risk and expected return. d) Illustration. + =- + = + = Yield Gains Capital Yield Current P P P P CF P P CF T r b b e b b ) ( 1 1 ) (--- + = t t t t t P P P CF r [ ] ) ( ) ( . ; ) ( ) ( ) ( ) ( ) ( 2 1 2 2 1 r r Deviation St r f r r r Variance r f r r turn e R Expected K j j j K j j j =- = = = = d i r r p- + + = + 1 ) 1 )( 1 ( 1 ( 29 ) ( 1 1 T r r T + = + Ec 173A RISK & RETURN OUTLINE p. 2 of 9 Table 1 Asset A Asset B SW Pr. C F P e r C F P e r 1. War, flood 2. War, drought 3. Peace, flood 4. Peace, drought 0.0 6 0.1 4 0.2 4 0.5 6 $ 1 2 4 3 $11 108 112 105 11.0 % 10.0 16.0 8.0 $ 4 4 4 $10 109 104 110 0.0 % 13.0 8.0 14.0 Expected Return Risk (r) = (r) = 10.4 % 3.3( %) (r) = (r) = 11.6 % 3.8( %) 3. Sources of Risk in Financial Securities: a) Total asset risk. b) Market or systematic risk. c) Firm-specific or non-systematic risk. 4. Three Rate of Return Concepts: a) Historical or ex post rates of return. b) Future or ex ante rates of return. c) Required rate of return. C. Risk Aversion 1. Investor Attitudes Toward Financial Risk: [Fig. 1] a) Risk averse. b) Risk neutral. c) Risk seeking. 2. The Theory of Risk Aversion: a) Diminishing marginal utility of wealth. [Fig. 2] b) Illustration -- U = 50 W. [Table 2] c) Expected utility maximization. d) Explanation. [Fig. 3] Table 2 Asset S Asset B Pr(j) r W 1 U(W 1 ) r W 1 U(W 1 ) j=1: 0.5 j=2: 0.5 % 50 $100 1250 1581.1 4 1767.7 7 20 % 30 $110 1150 1658.3 1 1695.5 8 Mean (r) 25 % 25 % $1,1 25 1674.4 6 25 % 5 % $1,1 25 1676.9 4 Seekin g Neutral Averse Fig. 1 (r) (r) 1 4 1 ) ( ; 1 2 1 ) ( ; ) ( 2 / 3 < - = = = = = = W W u dW dMU W W u MU W W u U w w Fig. 2 U = u(W) W Ec 173A RISK & RETURN OUTLINE p. 3 of 9 3. Measures of Risk Aversion: a) What is being measured....
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This note was uploaded on 10/20/2010 for the course ECON 173A taught by Professor Foster during the Fall '09 term at UCSD.

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Outline-4 - Ec 173AFINANCIAL MARKETS LECTURE OUTLINE...

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