9/22/2017 Assignment Print View

Score: 30/30 Points 100 %

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1. Award: 10 out of 10.00 points

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $150,000 or
$290,000 with equal probabilities of 0.5. The alternative risk-free investment in T-bills pays 6% per year.

a. If you require a risk premium of 7%, how much will you be willing to pay for the portfolio? (Round your
answer to the nearest dollar amount.Omit the "$" sign in your response.)

Price $ 196,429

b. Suppose that the portfolio can be purchased for the amount you found in part (a). What will be the
expected rate of return on the portfolio? (Round your answer to the nearest whole number. Omit the
"%" sign in your response.)

Rate of return 13 %

c. Now suppose that you require a risk premium of 12%. What is the price that you will be willing to pay?
(Round your answer to the nearest dollar amount. Omit the "$" sign in your response.)

Price $ 186,441

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $150,000 or
$290,000 with equal probabilities of 0.5. The alternative risk-free investment in T-bills pays 6% per year.

a. If you require a risk premium of 7%, how much will you be willing to pay for the portfolio? (Round your
answer to the nearest dollar amount.Omit the "$" sign in your response.)

$ 194,690 1%
Price

b. Suppose that the portfolio can be purchased for the amount you found in part (a). What will be the
expected rate of return on the portfolio? (Round your answer to the nearest whole number. Omit the
"%" sign in your response.)

Rate of return 13 1% %

c. Now suppose that you require a risk premium of 12%. What is the price that you will be willing to pay?
(Round your answer to the nearest dollar amount. Omit the "$" sign in your response.)

$ 186,441 1%
Price

Explanation:

a.
The expected cash flow is: (0.5 $150,000) + (0.5 290,000) = $220,000
With a risk premium of 7% over the risk-free rate of 6%, the required rate of return is 13%. Therefore, the
present value of the portfolio is:
$220,000 / 1.13 = $194,690

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9/22/2017 Assignment Print View

b.
If the portfolio is purchased for $194,690, and provides an expected cash inflow of $220,000, then the
expected rate of return [E(r)] is as follows:

$194,690 [1 + E(r)] = $220,000

Therefore, E(r) =13%. The portfolio price is set to equate the expected rate of return with the required rate
of return.

c.
If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$220,000/1.18 = $186,441

2. Award: 10 out of 10.00 points

Consider a portfolio that offers an expected rate of return of 11% and a standard deviation of 22%. T-bills
offer a risk-free 4% rate of return. What is the maximum level of risk aversion for which the risky portfolio is
still preferred to bills (assuming a utility function U = E(r) - A)? (Do not round intermediate
calculations and round final answer to 2 decimal places.)

Maximum level of risk aversion must be less than 2.89

Consider a portfolio that offers an expected rate of return of 11% and a standard deviation of 22%. T-bills
offer a risk-free 4% rate of return. What is the maximum level of risk aversion for which the risky portfolio is
still preferred to bills (assuming a utility function U = E(r) - A)? (Do not round intermediate
calculations and round final answer to 2 decimal places.)

Maximum level of risk aversion must be less than 2.89 1%

Explanation:

When we specify utility by U = E(r) 0.5A2, the utility level for T-bills is: .04
The utility level for the risky portfolio is:
U = .11 0.5 A (.22)2 = .11 .0242 A
In order for the risky portfolio to be preferred to bills, the following must hold:
.11 .0242A > .04 A < .07 / .0242 = 2.89
A must be less than 2.89 for the risky portfolio to be preferred to bills.

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9/22/2017 Assignment Print View

3. Award: 10 out of 10.00 points

Consider historical data showing that the average annual rate of return on the a particular stock portfolio
over the past 80 years has averaged roughly 9% more than the Treasury bill return and that the stock
portfolio standard deviation has been about 22% per year. Assume these values are representative of
investors expectations for future performance and that the current T-bill rate is 5%. Calculate the utility
levels of each portfolio for an investor with A = 2. Assume the utility function is U = E(r) 0.5 A2. (Do not
round intermediate calculations and round your final answers to 4 decimal places.)

WBills WIndex U(A = 2)
0.0 1.0 .0916
0.2 0.8 .0910
0.4 0.6 .0866
0.6 0.4 .0783
0.8 0.2 .0661
1.0 0.0 .0500

Consider historical data showing that the average annual rate of return on the a particular stock portfolio
over the past 80 years has averaged roughly 9% more than the Treasury bill return and that the stock
portfolio standard deviation has been about 22% per year. Assume these values are representative of
investors expectations for future performance and that the current T-bill rate is 5%. Calculate the utility
levels of each portfolio for an investor with A = 2. Assume the utility function is U = E(r) 0.5 A2. (Do not
round intermediate calculations and round your final answers to 4 decimal places.)

WBills WIndex U(A = 2)
0.0 1.0 .0916 0.001
0.2 0.8 .0910 0.001
0.4 0.6 .0866 0.001
0.6 0.4 .0783 0.001
0.8 0.2 .0661 0.001
1.0 0.0 .0500 0.001

Explanation:

Computing utility from U = E(r) 0.5 A2 = E(r) 2, we arrive at the values in the column labeled U(A =
2) in the following table:

WBills WIndex rPortfolio Portfolio 2Portfolio U(A = 2)

0.0 1.0 .1400 .2200 .0484 .0916
0.2 0.8 .1220 .1760 .0310 .0910
0.4 0.6 .1040 .1320 .0174 .0866
0.6 0.4 .0860 .0880 .0077 .0783
0.8 0.2 .0680 .0440 .0019 .0661
1.0 0.0 .0500 .0000 .0000 .0500

The column labeled U(A = 2) implies that investors with A = 2 prefer a portfolio that is invested 100% in the
market index to any of the other portfolios in the table.
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