FBE441_03_Investing_Risky_Asset

FBE441_03_Investing_Risky_Asset - FBE 441Investments Prof....

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FBE 441- Investments Prof. David Solomon Lecture 3: Investing in a Risky Asset Utility Maximization Theory Risk and Return Optimal investment with one risky and one riskless asset Readings: BKM chapter 6
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2 - How do we choose between risk . Utility Maximization Theory: Axioms & Practice - “Nothing ventured, nothing gained” . Risk and Return when investing in a Risky Asset Lecture Outline:
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3 Axioms of Finance (1) Investors prefer more to less (2) Investors are risk-averse (3) Money paid in the future is worth less than the same amount paid today (4) Financial markets are competitive
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4 Utility Theory: Facing Risk Consider investing $100,000 in risky assets A and B: Investment Decisions: (1) Between A or B, which would you choose? (2) Would you prefer instead a riskless alternative (have $103,000 for sure)? Invest in Asset A Pays $140,000 Pays $80,000 Prob 50% Prob 50% Invest in Asset B Pays $80,000 Pays $120,000 Prob 50% Prob 50%
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5 Utility Theory: Facing Risk Investment decisions in a more complete framework: Which would you now choose: A or B? US Economy Good: Have a Job Bad: No Job Prob 50% Prob 50% Asset A (Stocks) Good: Job + $140,000 Bad: No Job + $80,000 Prob 50% Prob 50% Asset B (Gold) Good: Job + $80,000 Bad: No Job + $120,000 Prob 50% Prob 50%
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6 Utility Theory: Facing Risk You can use asset B to reduce risk, i.e. “hedge” the exposure to risk. Another alternative to “hedge” – ex: short-sell asset A … Puzzle: Who invests in asset A? We would all want to bet against the stock market
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FBE441_03_Investing_Risky_Asset - FBE 441Investments Prof....

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