1.
Speculation involves engaging in risky investments primarily to capture the associated
risk premium. For risk-averse investors, the risk premium must be sufficiently large to
compensate for the inherent riskiness of the investment. Risk premiums serve as
incentives for investors to take on risk and are crucial considerations in investment
decision-making.
2. A fair game refers to a risky prospect with a zero risk premium, implying that the
expected return equals the required return for a risk-averse investor. Because there is no
compensation for risk, risk-averse investors would not undertake such investments. Fair
games are typically avoided in investment strategies due to the absence of potential
rewards for bearing risk.
3. Investors' preferences regarding expected returns and portfolio volatility can be
captured using utility functions, which assign higher utility values to higher expected
returns and lower utility values to higher portfolio variances. More risk-averse investors
exhibit greater aversion to risk and thus apply higher penalties to risky investments.
Indifference curves graphically represent these preferences, depicting combinations of
expected return and risk that yield the same level of utility for an investor.
4. The desirability of a risky portfolio for a risk-averse investor can be evaluated using the
certainty equivalent value, which represents the rate of return that, if received with
certainty, would yield the same utility as the uncertain returns of the portfolio. This
concept helps investors assess the risk-return trade-off and make informed decisions
regarding portfolio composition.
5. To mitigate risk, investors can shift funds from risky portfolios to risk-free assets, diversify
their risky portfolios, or hedge against specific risks. Diversification involves spreading
investments across multiple assets to reduce exposure to any single risk factor. Hedging
strategies aim to offset potential losses in one asset with gains in another, thereby
minimizing overall portfolio risk.
6. While Treasury bills (T-bills) are often considered risk-free assets in nominal terms, they
still carry some risk, albeit minimal, compared to other assets like long-term bonds and
stocks. Money market funds, which typically include T-bills and other short-term,
relatively safe obligations, are commonly referred to as risk-free assets for analytical
purposes due to their low default risk and stable returns.
7. The Sharpe ratio, calculated as the difference between the expected portfolio return and
the risk-free rate divided by the portfolio volatility, measures the risk-adjusted return of
a portfolio. The Capital Allocation Line (CAL) represents all possible combinations of the
risk-free asset and a risky asset, with the Sharpe ratio serving as the slope of this line.
Investors seek portfolios with steeper CALs, indicating higher expected returns for a
given level of risk.
8. The slope of the indifference curve reflects an investor's degree of risk aversion. Steeper
indifference curves indicate greater risk aversion, implying that investors require higher
risk premiums to accept additional risk. Understanding an investor's risk aversion helps
in determining their optimal portfolio allocation and risk management strategies.
9. The optimal allocation to the risky asset in an investor's portfolio is determined by
factors such as the risk premium, portfolio variance, and the investor's degree of risk
aversion. The optimal position, represented by the point where the indifference curve is
tangent to the CAL, reflects the trade-off between expected return and risk for the
investor.
Y* = E(rp)-rf/A σ^2P
10. A passive investment strategy involves minimal security analysis and focuses on investing
in the risk-free asset and broad portfolios of risky assets, such as the S&P 500 stock
portfolio. Investors adopting this strategy typically rely on historical data, such as the
mean historical return and standard deviation of the S&P 500, as proxies for expected
returns and risk. Studies suggest that the degree of risk aversion among investors,
estimated based on outstanding asset values, falls within a range of 2.0 to 4.0, with
typical values around 3.12.
