Risk Attitudes Certainty Equivalent (CE)is the amount of cash someone would require with certainty at a point in time to make the individual indifferent between that certain amount and an amount expected to be received with risk at the same point in time. 5-11
5-11 Certainty Equivalent (CE) is the amount of cash someone would require with certainty at a point in time to make the individual indifferent between that certain amount and an amount expected to be received with risk at the same point in time. Risk Attitudes
Risk Attitudes Certainty equivalent >Expected value Risk Preference Certainty equivalent Expected value Risk Indifference Certainty equivalent Expected value Risk Aversion Most individuals are risk averse 5-12
5-12 Certainty equivalent > Expected value Risk Preference Certainty equivalent = Expected value Risk Indifference Certainty equivalent < Expected value Risk Aversion Most individuals are Risk Averse. Risk Attitudes
Risk Attitude Example You have the choice between (1)$25,000 guaranteed or(2 an unknown outcome of $100,000(50% chance)or $o(50%chance) The expected value of the gamble is $50,000 You are Risk Averse if you choose $25,000 You are Risk Indifferent if you can't choose You have a risk Preference if you choose the gamble of $0 or $100,000 5-13
5-13 You have the choice between (1) $25,000 guaranteed or (2) an unknown outcome of $100,000 (50% chance) or $0 (50% chance). The expected value of the gamble is $50,000. You are Risk Averse if you choose $25,000. You are Risk Indifferent if you can‘t choose. You have a Risk Preference if you choose the gamble of $0 or $100,000. Risk Attitude Example
Determining portfolio Expected Return Rp=2(W)(R) Rp is the expected return for the portfolio, W; is the weight (investment proportion) for the jth asset in the portfolio, Ri is the expected return of the jth asset, m is the total number of assets in the portfolio. 5-14
5-14 RP = ( Wj )( Rj ) RP is the expected return for the portfolio, Wj is the weight (investment proportion) for the j th asset in the portfolio, Rj is the expected return of the jth asset, m is the total number of assets in the portfolio. Determining Portfolio Expected Return m j=1
Determining Portfolio Standard Deviation G=√2W9 W is the weight (investment proportion) for the jth asset in the portfolio, Wk is the weight (investment proportion for the kth asset in the portfolio, o is the covariance between returns for the jth and kth assets in the portfolio 5-1
5-15 Determining Portfolio Standard Deviation m j=1 m k=1 P = Wj Wk jk Wj is the weight (investment proportion) for the j th asset in the portfolio, Wk is the weight (investment proportion) for the k th asset in the portfolio, jk is the covariance between returns for the j th and k th assets in the portfolio