1.1.BKM Ch 06

• 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

Expected return in XS of r_f

• 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

• Rate of return that would cause the investor to be indifferent between risky and r_f investment.
• A portfolio is desirable only if its certainty ror > r_f

• 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.

Portfolio A dominates B if E(r_A) ≥ E(r_B) and σ_A ≤ σ_B, with at least one strict inequality

Line that connects all portfolios with the same utility value

y* = [E(r_P) - r_f] / Aσ_P²

• Line representing the different allocation possibilities between risky and r_f assets
• Equation: E(r_c) = r_{f +} S * σ_C
• Where S = [E(r_P) - r_f] / σ_P = Sharpe Ratio or Reward-to-Variability Ratio

Used when the risky index of the CAL is chosen as a broad index of common stocks (market proxy)

Describes a portfolio decision that avoids any direct or indirect security analysis.

• 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