The CFA text gives two equations for the utility function: U = E® - 0.005*Risk Aversion*standard deviation^2 SS8, pg 237 U = E® - Risk Aversion*standard deviation^2 (i.e. without the 0.005) SS11, pg 254 Does anyone know which equation to use when?
U = E® - 0.005*(risk score)*(variance of portfolio)
The one without the 0.005 is when maximizing choice of active managers
mpfree Wrote: ------------------------------------------------------- > The one without the 0.005 is when maximizing > choice of active managers Can you say more about that? What do you mean by “maximizing choice”?
“Maximizing choice” - What I mean is the utility calculation measures the best risk adjusted choice given the investors aversion to risk. So, in the case of the equation without the 0.005, you calculate the utility given the investor’s aversion to ACTIVE risk and choose the ACTIVE return manager that provides the highest value In the case of the equation with the 0.005, the investor choooses the asset mix (as oppose to the active manager) that provides the highest risk adjusted return (as opposed to active return) given the investor’s aversion to TOTAL risk. Hope I explained that better (and hope the explanation is correct).
if it is still a question, please note that the utility function with 0.005 scaling is only for those who cannot plug in percentages into the calculator in decimals: such as 10% = 0.10. If you can, the scaling factor is 0.5
One for when given information in decimal and other you post is number give you in percent. I remember when study before I got tricked with this.