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Level 102

Risk Aversion & Capital Allocation to Risk Assets


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Speculation
The act of trading in an asset, or conducting a financial transaction that involves considerable risk of losing up to all of the initial outlay, but offering the chance of substantial gains.
Gamble
To bet or wager on an uncertain outcome; the assumption of risk for no purpose but enjoyment fo the risk itself
Fair Game
A risky investment with a risk premium of zero
Heterogeneous Expectations
Investors on each side of a financial position see themselves as speculating rather than gambling
Risk Averse
You don't like risk
Utility
the amount of satisfaction one gets from a good or service
Certainty Equivalent Rate
The rate that risk-free investments would need to offer to provide the same utility score as the risky portfolio. It is the rate that, if earned with certainty, would provide a utility score equivalen…
Risk Neutral
A=0, judge risky prospects solely by their expected rates of return. The level of risk is irrelevant to the risk neutral investor, meaning that there is no penalty for risk. For this investor a portfol…
Risk Lover
A<0, happy to engage in fair games and gambles; this investor adjusts the E(r) upward to take into account the "fun" of confronting the prospect's risk
Mean-Variance (M-V) Criterion
Higher than or equal to E(r)
Indifference curve
a curve representing all the combinations of two goods or attributes such that the consumer is entirely indifferent among them
Capital Allocation
A process of how businesses divide their financial resources and other sources of capital to different processes, people and projects. Overall, it is management's goal to optimize capital allocation so that it generates as …
Price-Indexed Bond
The only risk-free asset in real terms. Even a default-free perfectly indexed bond is subject to interest rate risk, because real interest rates change unpredictably through time.
Risk-Free Asset
It is common to view Treasury bills as "the" risk-free asset because their short-term nature makers their values insensitive to interest rate fluctuations. Inflation uncertainty over the course of a few weeks or month…
Investment Opportunity Set
The set of feasible expected return and standard deviation pairs of all portfolios resulting from different values of y (weights)
Capital allocation line
a graph line that describes the combinations of expected return and standard deviation of return available to an investor from combining the optimal portfolio of risky assets with the risk-free asset
Reward-to-Volatility Ratio
The name of the slope of the CAL. The slope of the CAL equals the increase in the expected return of the complete portfolio per unit of additional standard deviation - incremental return per increme…
Investor's Borrowing Cost
Nongovernment investors cannot borrow at the risk-free rate. The risk of the borrower's default causes lenders to demand higher interest rates on loans.
Buy on margin
Borrowing to invest in the risky portfolio when you have a margin account with a broker. Margin purchases may not exceed 50% of the purchase value.