Collateralized Debt Obligations: Risk and Return Analysis - Prof. Arthur J. Keown, Study notes of Finance

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Collateralized Debt Obligations are bundles of mortgages that banks trade among each other. Nobody knew if the mortgages are bad are good so they aren’t being traded Value = PVBenefits = the sum of cashflows = cashflows / (1+k)^t Risk- the variability of possible outcomes over time II. Utility Theory and Risk Aversion a. Are people risk seekers or risk averters?

1. Risk Seekers: Las Vegas, gambling, Entertainment Value
2. Risk Averters: Insurance, diversifying, “Don’t put all your eggs in one basket b. A fair coin toss
3. Coin is tossed, heads win 5,100, 1000, 40,000 tails lose 5, 80, 600, 10,
4. The width of the distribution changed not the probability of winning III. Methods for describing the risk of an asset held in isolation
5. SD- Measure of absolute risk
6. Coefficient of variation (v)- relative variance risk/return a. Sigma is expressed in absolute terms. In order to evaluate the dispersion of outcomes with different R’s, the coefficient of variation is used b. Coef of variation = SD / expected value I. Risk and Return in a Portfolio a. Return in a portfolio i. The expected return on a portfolio is simply the weighted average expected return on the individual securities in the portfolio ii. Wa = % invested in A iii. Ra = expected return on A. WaRa + WbRb = expected return b. The expected standard deviation of a portfolio is generally less than the weighted average standard deviations of the individual securities c. Key: Finding assets that do not move together to diversify away risk. The key is in the covariance d.