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CHAPTER 6
Risk Aversion and Capital
Allocation to Risky Assets
Investments, 8th edition Bodie, Kane and Marcus
Slides by Susan Hine
McGrawHill/Irwin Copyright © 2009 by The McGrawHill Companies, Inc. All rights reserved.
Risk and Risk Aversion
• Speculation
– Considerable risk
• Sufficient to affect the decision – Commensurate gain
• Gamble
– Bet or wager on an uncertain outcome
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Risk Aversion and Utility Values
• Risk averse investors reject investment portfolios that are fair games or worse
• These investors are willing to consider only risk-free or speculative prospects with positive risk premiums
• Intuitively one would rank those portfolios as more attractive with higher expected returns
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Table 6.1 Available Risky Portfolios (Risk-free Rate = 5%)
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Utility Function
U = E(r)
Where
1
2
As2
U = utility
E ( r ) = expected return on the asset or portfolio
A = coefficient of risk aversion = variance of returns
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