Midterm exam 1 booklets: http://fin4335.garven.com/spring2018/midterm1_spring2018.pdf

Midterm exam 1 solutions: http://fin4335.garven.com/spring2018/midterm1_spring2018_solutions.pdf

]]>I just posted the formula sheet for the exam at http://fin4335.garven.com/spring2018/formulas_part1.pdf.

Regarding the exam, it consists of two sections. The first section consists of four multiple-choice questions worth 8 points each. The second section has two problems; the first problem is worth 32 points, and the second problem is worth 36 points. Thus, total points possible are 100.

Regarding content, the exam is all about stuff that we covered since the beginning of the semester; specifically, risk preferences, expected utility, certainty-equivalent of wealth, risk premiums, and the special cases of expected utility (i.e., the mean-variance model and the stochastic dominance model).

I will look forward to seeing all of you at the exam tomorrow. Good luck!

]]>Hi, I am Alexander Law, your graduate assistant for the Spring 2018 semester.

In light of your upcoming exam, I will be hosting office hours from 7-11pm tonight at the Financial Markets Center, Room 116 of the Business School.

You can also email me at Alexander_Law@baylor.edu

Thank you for your time and considerations.

]]>… are available at http://fin4335.garven.com/spring2018/ps4solutions.pdf…

]]>… are available at http://fin4335.garven.com/spring2018/ps3solutions.pdf.

]]>Here’s a brief synopsis of Finance 4335 course content to date; a full-size pdf version of this document is available at http://risk.garven.com/wp-content/uploads/2018/02/Finance-4335-Synopsis-February-4-2018.pdf (or by simply clicking on the page below).

]]>Four years ago, *The Economist *published a particularly interesting article about the determinants of risk aversion, entitled “Risk off: Why some people are more cautious with their finances than others”. Here are some key takeaways from this article:

1. Economists have long known that people are risk-averse; yet the willingness to run risks varies enormously among individuals and over time.

2. Genetics explains a third of the difference in risk-taking; e.g., a Swedish study of twins finds that identical twins had “… a closer propensity to invest in shares” than fraternal ones.

3. Upbringing, environment and experience also matter; e.g., . “…the educated and the rich are more daring financially. So are men, but apparently not for genetic reasons”.

4. People’s financial history has a strong impact on their taste for risk; e.g., “… people who experienced high (low) returns on the stock market earlier in life were, years later, likelier to report a higher (lower) tolerance for risk, to own (not own) shares and to invest a bigger (smaller) slice of their assets in shares.”

5. “Exposure to economic turmoil appears to dampen people’s appetite for risk irrespective of their personal financial losses.” Furthermore, a low tolerance for risk is linked to past emotional trauma.

]]>I received an email from a Finance 4335 student asking for further clarification of the two methods for calculating risk premiums which we covered in class last Thursday. Under the so-called “exact” method, one 1) calculates expected utility, 2) sets expected utility equal to the utility of the certainty-equivalent of wealth, 3) solves for the certainty-equivalent of wealth, and 4) obtains the risk premium by calculating the difference between expected wealth and the certainty-equivalent of wealth. A numerical example of this approach is provided on page 3 of the http://fin4335.garven.com/spring2018/lecture6.pdf lecture note. On the other hand, the Arrow-Pratt method is an alternative method for calculating the risk premium which is based upon Taylor series approximations of expected utility of wealth and the utility of the certainty equivalent of wealth (the derivation for which appears on pp. 16-18 of this same lecture note). Both of these approaches for calculating risk premiums are perfectly acceptable for purposes of Finance 4335.

The value added of Arrow-Pratt is that it analytically demonstrates how risk premiums depend upon two factors: 1) the *magnitude* of the risk itself (as indicated by variance), and 2) the *degree* to which the decision-maker is risk averse. For example, we showed in class on Thursday that the Arrow-Pratt coefficient for the logarithmic investor (for whom U(*W*) = ln *W*) is twice as large as the Arrow-Pratt coefficient for the square root investor (for whom *U*(*W*) = *W*^{.5}); 1/W for the logarithmic investor compared with .5/W for the square root investor. Thus, the logarithmic investor behaves in a more risk averse than the square root investor; other things equal, the logarithmic investor will prefer to allocate less of her wealth to risky assets and buy more insurance than the the square root investor. Another important insight yielded by Arrow-Pratt (at least for the utility functions considered so far in Finance 4335) is the notion of *decreasing absolute risk aversion*. Other things equal, investors become less (more) risk averse as wealth increases (decreases).

Tim Harford also features the index fund in his “Fifty Things That Made the Modern Economy” radio and podcast series. This 9 minute long podcast lays out the history of the development of the index fund in particular and the evolution of so-called of passive portfolio strategies in general. Much of the content of this podcast is sourced from Vanguard founder Jack Bogle’s September 2011 *WSJ* article entitled “How the Index Fund Was Born” (available at https://www.wsj.com/articles/SB10001424053111904583204576544681577401622). Here’s the description of this podcast:

“Warren Buffett is the world’s most successful investor. In a letter he wrote to his wife, advising her how to invest after he dies, he offers some clear advice: put almost everything into “a very low-cost S&P 500 index fund”. Index funds passively track the market as a whole by buying a little of everything, rather than trying to beat the market with clever stock picks – the kind of clever stock picks that Warren Buffett himself has been making for more than half a century. Index funds now seem completely natural. But as recently as 1976 they didn’t exist. And, as Tim Harford explains, they have become very important indeed – and not only to Mrs Buffett.”

Warren Buffett is one of the world’s great investors. His advice? Invest in an index fund

From November 2016 through October 2017, *Financial Times *writer Tim Harford presented an economic history documentary radio and podcast series called *50 Things That Made the Modern Economy. *This same information is available in book under the title “Fifty Inventions That Shaped the Modern Economy“. While I recommend listening to the entire series of podcasts (as well as reading the book), I would like to call your attention to Mr. Harford’s episode on the topic of insurance, which I link below. This 9-minute long podcast lays out the history of the development of the various institutions which exist today for the sharing and trading of risk, including markets for financial derivatives as well as for insurance.

“Legally and culturally, there’s a clear distinction between gambling and insurance. Economically, the difference is not so easy to see. Both the gambler and the insurer agree that money will change hands depending on what transpires in some unknowable future. Today the biggest insurance market of all – financial derivatives – blurs the line between insuring and gambling more than ever. Tim Harford tells the story of insurance; an idea as old as gambling but one which is fundamental to the way the modern economy works.”