Risk and Risk Aversion

Chapter 6

Risk - Uncertain Outcomes

W1 = 150 Profit = 50

W = 100
1-p = .4 W2 = 80 Profit = -20

E(W) = pW1 + (1-p)W2 = 6 (150) + .4(80) = 122

s2 = p[W1 - E(W)]2 + (1-p) [W2 - E(W)]2 =

.6 (150-122)2 + .4(80=122)2 = 1,176,000

s = 34.293
6-2 1-2

Risky Investments with Risk-Free

Risky Inv.

W1 = 150 Profit = 50

100

1-p = .4 Risk Free T-bills

W2 = 80 Profit = -20
Profit = 5

Risk Premium = 17

6-3 1-3

Risk Aversion & Utility

Investors view of risk
Risk Averse
Risk Neutral Risk Seeking

Utility
Utility Function
U = E ( r ) - .005 A s 2 A measures the degree of risk aversion

6-4 1-4

Risk Aversion and Value:

U = E ( r ) - .005 A s 2 = .22 - .005 A (34%) 2 Risk Aversion A Value High 5 -6.90 3 4.66 Low 1 16.22

T-bill = 5%

6-5 1-5

Dominance Principle
Expected Return 4 2 1 Variance or Standard Deviation 3

2 dominates 1; has a higher return 2 dominates 3; has a lower risk 4 dominates 3; has a higher return
6-6 1-6

Utility and Indifference Curves

Represent an investors willingness to tradeoff return and risk. Example Exp Ret 10 15 St Deviation U=E ( r ) - .005As2 20.0 25.5 2 2

20
25

30.0
33.9

2
2
6-7 1-7

Indifference Curves
Expected Return

Increasing Utility
Standard Deviation
6-8 1-8

Expected Return
Rule 1 : The return for an asset is the probability weighted average return in all scenarios.

E (r ) = P( s )r ( s )
s

6-9 1-9

Variance of Return
Rule 2: The variance of an assets return is the expected value of the squared deviations from the expected return.

P( s)[ r ( s) E (r )] s = s
2

6-10 1-10

Return on a Portfolio
Rule 3: The rate of return on a portfolio is a weighted average of the rates of return of each asset comprising the portfolio, with the portfolio proportions as weights. r p = W 1r 1 + W 2r 2 W1 = Proportion of funds in Security 1

W2 = Proportion of funds in Security 2

r1 = Expected return on Security 1 r2 = Expected return on Security 2
6-11 1-11

Portfolio Risk with Risk-Free Asset

Rule 4: When a risky asset is combined with a risk-free asset, the portfolio standard deviation equals the risky assets standard deviation multiplied by the portfolio proportion invested in the risky asset.

s p = wriskyasset s riskyasset
6-12 1-12

Portfolio Risk

Rule 5: When two risky assets with variances s12 and s22, respectively, are combined into a portfolio with portfolio weights w1 and w2, respectively, the portfolio variance is given by: sp2 = w12s12 + w22s22 + 2W1W2 Cov(r1r2) Cov(r1r2) = Covariance of returns for Security 1 and Security 2
6-13 1-13