Professional Documents
Culture Documents
P1 P D
H PR 0 1
P 0
P0 price in period 0
P1 price in period 1
D1 the dividend paid during the period
P 1P 0
CG=
P0
D1
DY =
P0
The HPR is not known before P1 because the P1 can not be predicted with
certainty
When a person buys a stock at P0 then he does not known what P1 is
Probabilities are used to estimate the return which is the expected return
E ( r )= piri
pi = probability of i
ri = return of i
E(r )
ri
Var ( r )=pi
E (r )
ri
( r)= pi
= 0.011990.5
= 0.01095
Risk free rate the rate of return on the risk free asset such as
government bonds
The difference in any particular period between the actual rate of return
on an asset and the actual risk-free rate is called the excess return.
The degree to which investors are willing to commit funds depends on risk
aversion. Investors are mostly risk averse so the risk premium is greater
than 0
Assets are risky and the investors are rewarded for holding them
In theory, there must always be a positive risk premium on stocks in order
to induce risk averse investors to hold the existing supply of stocks.
Investors, or the market, price risky asset so that the risk premium
compensates for the risk of the expected excess return
Trade off between reward and risk is captured by the Sharpe Ratio
The trade off between risk premium, E(er) and risk, the of the er is the
Sharpe ratio
It measures the attractiveness of the portfolio.
The higher the Sharpe ratio the more attractive the portfolio is.
Risk Premium
Sharpe Ratio=
of theexcess return
E(XR)
SR=
( XR)
XR = E(R) i
URA = MURA
URA < 0
URN = MURN
URN = 0
URS = MURS
URS > 0
EP expected payoff
EU expected utility
UEP utility of expected payoff
Risk aversion:
There is a gamble
EP = 0.6(1000) + 0.4(0)
EP = 600
EU = 0.6(100) + 0.4(0)
EU = 60
UEP > EU
If U(X) is less than 0 then the investor is risk averse so his UEP is greater
than EU
The UEP eliminates the risk but the EU has risk
The risk averse investor is willing to pay an amount to eliminate the risk
If U(X) is more than 0 then the investor is risk seeking so his UEP is less
than EU
The UEP eliminates the risk but the EU has risk
The risk seeking investor is willing to pay an amount to play the risky
gamble
The expected value does not take the risk preferences of a person into
account
There is a prize A of 10000000 at 10% chance and there is B of
1000000 at 100% chance
The expected value of both is 1000000 but a risk averse person will
value the B more
The risk seeking person will value A more
EP = 0.50(100) + 0.50(36)
EP = 68
U = P0.5
U1 = 1000.5
U1 = 10
U2 = 360.5
U2 = 6
The E(U) is then found
EU = pU1 + pU2
EU = 0.50(10) + 0.50(6)
EU = 8
UEP = 680.5
UEP = 8.26
The certain income that will give person the same utility as EU can be
found
P = EU2
P = 82
P = 64
RP = EP CE
Risk premium:
The degree of risk aversion can be shown with the curvature of the utility
curve
The less the curve, the less risk averse the person is
The more the curve, the more risk averse the person is
The utility curve shows the person is less risk averse as it is not very
curved
The utility curve shows that even though income increases, the MU does
not change much
The utility curve shows the person is more risk averse as it is very curved
The utility curve shows that as income increases, the MU increases by
less than before
The E represents the income needed for the expected utility which is the
certainty equivalent
The C represents the expected income and the utility it brings the person
The distance between E and C is the risk premium
U = 0.4W0.5
PS = 0.01
PN = 0.99
UEW = 0.4x39600000.5
UEW = 795.99
W = (U/0.4)0.5
W = (792/0.4)0.5
W = 3920400
If there are 2 portfolios then the investor prefers the portfolio with higher
E(r) and lower P
The portfolio mean variance dominates the other if it has a higher E(r)
and lower
wi = 1
E(ri) = ri
E(rp) = wiri
The household decides to invest 15% of its wealth in hedge fund X with
E(r) of 10% and 85% in risk free asset Y with E(r) of 3%