EXERCISE A1

Due: March 31, 2015

PART 1 - BASIC
QUESTION 1
Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will
be either $70,000 or $200,000 with equal probabilities of 0.5. The alternative riskfree investment in T-bills pays 6% per year.
a. If you require a risk premium of 8%, how much will you be willing to pay for
the portfolio?

E[R] = 6%+8%= 14% = (0.5 70, 000 + 0.5 200, 000)/P 1

1.14 = 135, 000/ P
P = 135, 000 /1.14
P = 118,421.05
b. Suppose that the portfolio can be purchased for the amount you found in ( a).
What will be the expected rate of return on the portfolio?

E[R] = 135 000 118421, 0526/ 118421, 0526 = 14%

c. Now suppose that you require a risk premium of 12%. What is the price that
you will be willing to pay?

E[R] = 6%+12%= 18% = (0.5 70, 000 + 0.5 200, 000)/P 1

1.18= 135,000/P
P=135,000/ 1.18
P = 114,406.78
d. Comparing your answers to (a) and (c), what do you conclude about the
relationship between the required risk premium on a portfolio and the price at
which the portfolio will sell?

The higher the risk premium, the lower the price.

QUESTION 2
Consider a portfolio that offers an expected rate of return of 12% and a standard
deviation of 18%. T-bills offer a risk-free 7% rate of return. Assume that investors
have a utility function given by U= E(r)0.005A2, where A is the coefficient of
absolute risk aversion. What is the maximum level of risk aversion for which the risky
portfolio is still preferred to bills?

Portfolio U= E(r) - 0.005A2 U= 12%- 0.005A*0.182

TBills U= E(r) - 0.005A2 U= 7%- 0.005A*02= 7%
7%=12%-0.005A*0.182 A= 308.6419
The investor will prefer the portfolio if A<308.6419.

QUESTION 3
Consider historical data showing that the average annual rate of return on the S&P
500 portfolio over the past 85 years has averaged roughly 8% more than the
Treasury bill return and that the S&P 500 standard deviation has been about 20%
per year. Assume these values are representative of investors expectations for
future performance and that the current T-bill rate is 5%.
a. Calculate the expected return and variance of portfolios invested in T-bills
and the S&P 500 index with weights as follows:
b.

Calculate the utility levels of each portfolio for an investor with A = 2,

assuming a utility function of the form U= E(r)0.005A2. What do you
conclude?

c. What if the investor had a level of risk aversion A = 3. What do you conclude
in this second case?
W bills

W index

Expected Return

1.0

0.2
0.4
0.6
0.8
1.0

0.8
0.6
0.4
0.2
0

0*5%
+1*13%=13%
11.4%
9.8%
8.2%
6.6%
5%

Maximized when only investing in S&P.

Stand
dev
20%

Variance

Ut (A=2)

4%

12.96%

Ut
(A=3)
12.94%

16%
12%
8%
4%
0%

2.56%
1.44%
0.64%
0.16%
0%

11.37%
9.78%
8.19%
6.59%
5%

11.36%
9.77%
8.19%
6.59%
5%

QUESTION 4
Consider the following two investments:
Investment A
$ Outcome
Probability
7
2/5
10
1/5
14
2/5

Investment B
$ Outcome
Probability
5
1/2
12
1/4
20
1/4

a. Which is preferred if the utility function is U (W) = -W - 0.04W2?

Wa= 10.4 and Wb=10.5

U(Wa)= (-10.4) - .04(10.4)^2 = -14.726
U(Wb)= (-10.5) - .04(10.5)^2 = -14.91
Hence A is preferred over B.
b. For investment B, the probability of a $5 return is 1/2 and of a $12 return is
1/4. How much would these probabilities have to change so that the investor is
indifferent between investments A and B?

X probability of A and Y probability of B

7(2/5) + 10 (1/5) + 14 (2/5) = 5(x) + 12(y) + 20(1/4)
(10.4) 5 = 5(x) + 12 (y)
5.4 = 5x+12y and x + y = 3/4
5.4 = 5x + 12 (3/4 - x)

y= 0.235 and x= 0.514

PART 2 - INTERMEDIATE
QUESTION 5
Suppose that your wealth is $250,000. You buy a $200,000 house and invest the
remainder in a risk-free asset paying an annual interest rate of 6%. There is a
probability of .001 that your house will burn to the ground and its value will be
reduced to zero. With a log utility of end-of-year wealth, how much would you be
willing to pay for insurance (at the beginning of the year)? (Assume that if the house
does not burn down, its end-of-year value still will be $200,000.)

Without fire, your wealth is $253000 and with $53000 (50000*1.06)

E[U]= 0.001*log(53000 + 0)+0.999*log(200000 + 53000) = 5.39633
Log (Wo + CE) = 5.39633
10^(5.39633) = $249,074.92 = 53,000 + CE
CE =
(50 000 P)*1.06+200,000=252,604.85 P= 372,78
QUESTION 6
If the cost of insuring your house is $1 per $1,000 of value, what will be the
certainty equivalent of your end-of-year wealth if you insure your house at:

200000/1000=200 premium
a. its value.
Investment = 49900 = 50000 -200*1/2 => 49900*1.06=52894
E(u)= 0.001*ln(52894)+0.999*ln(252894)=12,43
CE= exp (12.43)=250196.02
b. Its full value.
Investment = 49800 => 49800*1.06=52788
E(u)= 0.001*ln(52788)+0.999*ln(252788)=12,438
CE= exp (12,438)=252205.62
c. 1 times its value.
Investment = 49700 => 49700*1.06=52682
E(u)= 0.001*ln(52682)+0.999*ln(252682)=12,438
CE= exp (12,438)=252205.62

PART 3 - ADVANCED
QUESTION 7
Consider a two-date (one-period) economy. Define the inter-temporal utility function
over consumption as V(c1,c2) = U(c1) + U(c2).
a. Show mathematically that the agent with this utility function will always
prefer a smooth consumption stream to a more variable one with the same
mean, that is,

U ( c )+ U ( c ) >U ( c1 ) +U (c 2)
c1 +c
2
.
c =
2

if

b. Verify this result with the utility function

1

U ( c )=

c
1

QUESTION 8
Suppose that a risk-averse individual can only invest in two risky securities A and B,
whose future returns are described by identical but independent probability
distributions. How should he/she allocate his/her given initial wealth (normalized to 1
for simplicity) among these two assets so as to maximize the expected utility of next
period's wealth?

QUESTION 9
Consider the portfolio choice problem of a risk-averse individual with a strictly
increasing utility function. There is a single risky asset, and a risk-free asset.
Formulate an investor's choice problem and comment on the first-order conditions.
What is the minimum risk premium required to induce the individual to invest all his
wealth in the risky asset? (Find your answer in terms of his initial wealth, absolute
risk aversion coefficient, and other relevant parameters.)
Hint: Take a Taylor series expansion of the utility of next period's random wealth.