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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.

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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.

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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.

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Different people have different optimal portfolios.

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Posted by bparke at March 24, 2005 09:29 PM

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