1.1.BKM Ch 06

  1. Risk-Free (rf) asset
    • T-Bills are used as benchmark because:
    • 1. free of default risk
    • 2. short term nature makes it insensitive to interest rate risk
    • 3. short term nature minimize exposure to inflation uncertainty
  2. Risk Premium
    Expected return in XS of rf
  3. Utility score of risky portfolio
    • Used to quantify investor's risk aversion (determines if one risky prospect is better than another)
    • U = E(r) - 0.5Aσ2
    • where A = assumed risk aversion
  4. Certainty equivalent rate of return
    • Rate of return that would cause the investor to be indifferent between risky and rf investment.
    • A portfolio is desirable only if its certainty ror > rf
  5. Different types of investors
    • Risk averse (A > 0): only considers inv w/ positive risk premium
    • Risk neutral (A = 0): judges risks solely on E(r)
    • Risk lover (A < 0): willing to engage in fair games and gambles
    • A can be estimated by determining the price at which the investor is indifferent between buying insurance or bearing the risk.
  6. Mean-variance (M-V) criterion
    Portfolio A dominates B if E(rA) ≥ E(rB) and σA ≤ σB, with at least one strict inequality
  7. Indifference curve
    Line that connects all portfolios with the same utility value
  8. Utility maximization point
    y* = [E(rP) - rf] / AσP2
  9. Capital Allocation Line
    • Line representing the different allocation possibilities between risky and rf assets
    • Equation: E(rc) = rf + S * σC
    • Where S = [E(rP) - rf] / σP = Sharpe Ratio or Reward-to-Variability Ratio
  10. Capital Market Line (CML)
    Used when the risky index of the CAL is chosen as a broad index of common stocks (market proxy)
  11. Passive strategy
    Describes a portfolio decision that avoids any direct or indirect security analysis.
  12. Common criticism of the passive strategy
    • Undiversified: 25% of index is invested in top 10 firms. However funds usually adopt similar weights
    • Top-Heavy: 500 top firms = 77% of mkt
    • Chasing Performance
    • You Can Do Better: evidence shows it's rare & rdm
Card Set
1.1.BKM Ch 06
BKM Chap 09