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March 24, 2005
Risk vs. Expected Return
We can assess the value of a risk in terms of the curvature of an agent's utility function.
This leads to indifference curves for combinations of expected return and risk as measured by statistical standard deviation.
We can also derive a budget constraint.
Put these two elements together, and you have a diagram that explains how people determine the optimal portfolio when they can hold either a risk-free asset or a risky asset.
Different people have different optimal portfolios.
Posted by bparke at March 24, 2005 09:29 PM