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Unformatted text preview: Theories: dealing with risk and return (portfolio theory) and creating the interest rate • Risk and return: the portfolio theory • Modern portfolio theory – the basics 1. There is a choice of assets 2. The assets differ in risk and return 3. Economic investors will hold mixed portfolios to produce their desired risk and return characteristics 4. The portfolio approach is a general equilibrium approach (therefore deals with income and substitution effects) • Risk and return – Return on an asset: mean return over a period of time – Risk: the probability that the actual return may differ from expected return • Can be both ways (larger and smaller) • ‘Risk aversion’ – People are more averse to losing than winning: why? » Diminishing marginal utility of wealth • Describing an asset: – The characteristics of any asset can be described by the mean value and the variance of its returns • Diversification – The degree of risk can be reduced by diversification – The most dramatic reduction in risk comes in the early stages of diversification • Take two assets that are perfectly correlated…with increasing the number of assets, there will be increasing chances of less than perfect correlation • ‘Market risk’ and ‘specific risk’ – Total risk = market risk + specific risk 1. No rational riskaverse investor will incur specific risk, since it is unnecessary...
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 Spring '11
 Draxler
 Inflation, Interest, Interest Rate, · Keynes, high liquidity premiums

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