July 14 Slides.1

# July 14 Slides.1 - 7/13/2011 Chapter6

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7/13/2011 1 Chapter 6 Risk Aversion and Capital Allocation to Risky Assets Chapter 6 Risk Aversion and Capital Allocation to Risky Assets Risk Aversion -Part±I Combining a Risk-free Asset with a Risky Asset -Part II

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7/13/2011 2 What do economists do? Chapter 6 Risk Aversion and Capital Allocation to Risky Assets 1. Solve optimization problems Maximize: Objective Function Subject to: Constraints 2. Look for equilibria In Chapter 5 we encountered two measures that help characterize a distribution: mean & variance. Chapter 6 Risk Aversion and Capital Allocation to Risky Assets In Chapter 6 we will start to look at the investor’s optimization problem. To do that we need to define what the investor cares about (preferences) and what the investor’s choice set looks like. We will use the notion of expected utility to describe preferences. This discussion is motivated by the notion of risk aversion. We will then look at the idea of combining different types of assets and the resulting portfolio’s characteristics.
7/13/2011 3 That is, look at the following optimization problem: Maximize: Expected Utility Chapter 6 Risk Aversion and Capital Allocation to Risky Assets Subject to: Constraints on E(r) and σ This will allow us to visualize the investor’s problem with a graph of the “E- σ ” space: E(r) σ Risk and Risk Aversion Jakob Bernoulli (1654 – 1705) Nicolaus Bernoulli (1662 – 1716) Johann Bernoull (1667 1748 Johann Bernoulli (1667 – 1748) Nicolaus Bernoulli (1687 – 1759) * Nicolaus Bernoulli (1695 – 1726) Daniel Bernoulli (1700 – 1782) * Johann Bernoulli (1710 – 1790) Johann Bernoulli (1746 – 1807) Daniel Bernoulli (1751 – 1834) Jakob Bernoulli (1759 – 1789) Christoph Bernoulli (1782 – 1863) Johann Gustav Bernoulli (1811 – 1863)

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7/13/2011 4 The St. Petersburg Paradox Peter tosses a coin and continues to do so until
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## This note was uploaded on 02/02/2012 for the course ECON 442 taught by Professor Grahamlemke during the Spring '11 term at Binghamton.

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July 14 Slides.1 - 7/13/2011 Chapter6

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