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1. a. The expected cash flow is: (0.5 x $70,000) + (0.5 x 200,000) = $135,000 With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is 14%. Therefore, the present value of the portfolio is: $135,000/1.14 = $118,421 b. If the portfolio is purchased for $118,421, and provides an expected cash inflow of $135,000, then the expected rate of return [E(r)] is derived as follows: $118,421 x [1 + E(r)] = $135,000 Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate or 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: $135,000/1.18 = $114,407 d. For a given expected cash flow, portfolios that command greater risk premia must sell at lower prices. The extra discount from expected value is a penalty for risk. When we specify utility by U = E(r) – .005Aσ2, the utility from bills is 7%, while that from the risky portfolio is U = 12 – .005A x 182 = 12 – 1.62A. For the portfolio to be preferred to bills, the following inequality must hold: 12 – 1.62A > 7, or, A < 5/1.62 = 3.09. A must be less than 3.09 for the risky portfolio to be preferred to bills. Points on the curve are derived as follows: U = 5 = E(r) – .005Aσ2 = E(r) – .015σ2 The necessary value of E(r), given the value of σ2, is therefore: σ 0% 5 10 15 σ2 0 25 100 225

2.

3.

E(r) 5.0% 5.375 6.5 8.375 5-1

A=3) 5 4 U(Q5.A=0) σ U(Q6. for Question 3).20 25 400 625 11. labeled Q4 (for Question 4).375 The indifference curve is depicted by the bold line in the following graph (labeled Q3.A=4) U(Q3. E(r) U(Q4. utility is: U = E(r) – .02σ2 = 4 leading to the equal-utility combinations of expected return and standard deviation presented in the table below. The indifference curve is the upward sloping line appearing in the graph of Problem 3. 4.A<0) 5-2 . Repeating the analysis in Problem 3.0 14.005Aσ2 = E(r) – .

The corresponding indifference curve is downward sloping. A risk lover. When A increases from 3 to 4. The corresponding utility is simply equal to the portfolio's expected return. and labeled Q6.005 x 4 x σ2.12%)___ market 6.σ 0% 5 10 15 20 25 σ2 0 25 100 225 400 625 E(r) 4.20" 5-3 $. A = 0. 10.00% 4. 8. The lower level of utility assumed for Problem 4 (4% rather than 5%).50 The indifference curve in Problem 4 differs from that in Problem 3 in both slope and intercept. 3. the higher risk aversion results in a greater slope for the indifference curve since more expected return is needed to compensate for additional σ. as drawn in the graph of Problem 3. [Utility for each portfolio = E(r) – .20" Portfolio e!iation x17.0 _______________________________________________________________(=w #%.0 + Wmarket x = 5" #. The coefficient of risk aversion of a risk neutral investor is zero.50 6.] b The portfolio expected return can be computed as follows: Portfolio stan ar $.00 8. drawn in the graph of Problem 3. rather than penalizing portfolio utility to account for risk. shifts the vertical intercept down by 1%. 9. derives greater utility as variance increases. [When investors are risk neutral.50 12. and labeled Q5. This amounts to a negative coefficient of risk aversion. Wbills x 0.00 16.) 4. 7.#2" . We choose the portfolio with the highest utility value. The corresponding indifference curve in the expected return-standard deviation plane is a horizontal line. 5. and the portfolio with the highest utility is the one with the highest expected return.

8 .( .20 &. Your reward-to-variability ratio '0.52 (./bills in sto0k A in sto0k 1 in sto0k 2 12.97 5.& #.(& 5.93 5.09 187.(" +n!estment .2 0. = = . Standard deviation = .6 .55 5.& .69 105.0 ##.2 .0 .005 Aσ2 = E(r) – .'( %. It shows that the more risk averse investors will prefer the position with 20% in the market index portfolio.2% (.67 4.20 $.2 .ro.2 0 9.&4 5.0 $.% × #&" = 15% per year.' × &" + .0 17.00 #'.7 10.0 1..% × 2&" = #$.42 0 293.#" 2&.85 3. 13.% × 2%" = .6 .47 46. Expected return = .20% 8.68 5. The column labeled U(A = 5) in the table above is computed from U = E(r) – .0" #&.92 11. we arrive at the following table. Wbills Wmarket E(r) σ )σ2 U(A=') U(A=5) ******************************************************************* 0.005 x Aσ2 = E(r) – .4 .20 $.4 .%0 #0.52 6.4 .0#5σ2 (because A = 3).8 1.27 6.0" in . .% × 40" = #5.$" 2'.% × ''" = .42 0 Computing the utility from U = E(r) – .84 5. 5-4 .70 0 4.12 13.66 5.0 1.36 7.( .20 $.87 3.&5 '. 5 5 5 5 5 .4 .88 5.54 5. rather than the 40% market weight preferred by investors with A = 3.80 5. #4.0 The utility column implies that investors with A = 3 will prefer a position of 60% in the market and 40% in bills over any of the other positions in the table.'5%# 16. those with A = 5 will prefer 20% in the market and 80% in bills.ortions.51 5.20 $.'5%# Client's reward-to-variability ratio = = .025σ2 (since A = 5).

then solving for y we get: #( = & + l05.3571) P Client σ ( % ) 17.4" .0" in sto0k 2 σC = .(" in sto0k A .4" in sto0k 1 .& × σP = . #&.& × 40" = '2. σC = 5 × 2&". to get an expected return of 16% the client must invest 80% of total funds in the risky portfolio and 20% in T-bills.& × 2&" = 22.& Therefore. If your client wants a standard deviation of at most 18%.6429 = 64.29% in the risky portfolio. a. an 5 = = . a.30 25 20 E( r) 15 % 10 5 0 0 10 20 30 40 CA L (Slope = . E(r2) = rf + 3E(rP) – rf4 5 = 8 + l0y If the expected return of the portfolio is equal to 16%.& × 2%" = 2#. Investment proportions of the client's funds: 20% in T-bills.& × ''" = 2(.er 5ear 0. 5-5 . b. then y = 18/28 = . .

44% in the risky portfolio and 63. My fund allows an investor to achieve a higher mean for any given standard deviation than would a passive strategy. a higher expected return for any given level of risk.20 21. Slope of the CML = = .'(44 So the client's optimal proportions are 36.(44" σC= . a. With 70% of his money in my fund's portfolio the client gets a mean return of 15% per year and a standard deviation of 19.'(44 × 2& = #0.42$ = #4. E(r2) = & + #05 = & + .3571 CML: Slope = .'(44 × #0 = ##. a.56% in Tbills. If he shifts that money to the passive 5-6 .. b. a.6% per year.b. E(r2) = & + #056 = & + . CML and C AL 18 16 14 12 10 8 6 4 2 0 0 10 Standard Deviation 20 30 Expected Retrun CA L: Slope = . b.e.20" 20.(42$ × #0 = & + (.42$" 56 = = = = .20 The diagram is on the following page. i. #$.

he can achieve it with a lower standard deviation using my fund portfolio.% × σM = .5% and a decline in the standard deviation from 19. Since both mean return and standard deviation fall. rather than the passive portfolio.5%.5%.σC = 5 × 2&" = . y: E(r2) = & + 5(#& − &) = & + #05 Because our target is: E(rC) = 11.5%.5" Therefore.% × (#' – &) = ##.e of 2A9 :it. E(r2) = & + . rf = 8% and E(rM) = 13%.&". Clients will be indifferent between my fund and the passive portfolio if the slope of the after-fee CAL and the CML are equal. the same 11. The fee would reduce the reward-to-variability ratio. 5 = = . the proportion that must be invested in my fund is determined as follows: ##..%3E(r 7) − rf4 In this case. the shift entails a decline in the mean from 14% to 11.5%.5% expected return can be achieved with a standard deviation of only 9.20. The disadvantage of the shift is that if my client is willing to accept a mean return on his total portfolio of 11. his overall expected return and standard deviation become: E(r2) = rf + .'5 The standard deviation of the portfolio would be. Let f denote the fee. Therefore.5% using the passive portfolio. To achieve a target mean of 11. 8lo.e.20 5-7 .5" The standard deviation of the complete portfolio using the passive portfolio would be: σC = . Thus. it is not yet clear whether the move is beneficial or harmful. i. we first write the mean of the complete portfolio as a function of the proportions invested in my fund portfolio.'5 × 2&" = $.portfolio (which has an expected return of 13% and standard deviation of 25%).5 = & + #05. the slope of the CAL. b.% × 25" = #%.6% to 17. by using my portfolio. Setting these slopes equal we get: = .8% as opposed to the standard deviation of 17. fee = = Slope of CML (which requires no fee) = = .

The fee that you can charge a client is the same regardless of the asset allocation mix of your client's portfolio. E(r7) = #'"< rf = &"< σM = 25"< A = '. then the CML and indifference curves are as followsE(r) borrow lend 13 P CAL CML 9 5 σ 25 24. 23. You can charge a fee that will equalize the reward-to-variability ratio of your portfolio with that of your competition.0 (so that the investor is a lender).20 = 5. The formula for the optimal proportion to invest in the passive portfolio is: 56 = Wit.4" .( f = #0 − 5. If rf = 5" b>t r= $". a.#0 − f = 2& × .2286 b.er 5ear 22. risk aversion must be large enough that: 5= ? # 5-8 .5. :e =et y* = = . For y to be less than 1. The answer here is the same as in 9b.( = 4.

osition. b.&$ +n bet:een. Α < = .Α > = #.&$ ≤ A ≤ 2. The graph of problem 23 has to be redrawn here with E(r) = 11% and σ = #5" Aor a len in= .(4 ≤ Α ≤ #.(4 For values of risk aversion within this range. risk aversion must be small enough that: 5= @ # Α < = . 5 = # for . a.(% Aor a borro:in= .2& For y to be greater than 1. Α > = 2.osition. the investor neither borrows nor lends.2& 25. but instead holds a complete portfolio comprised only of the optimal risky portfolio: 5 = # for .0 (so that the investor is a borrower).(% 5-9 .

E(r) M 13 11 9 CML CAL F 5 σ 15 25 2(. t. 5".assi!e .e reason is t. an :e sol!e for f from= f = ( − = #. t.e rele!ant risk/free rate.e a0ti!e an .er risk/. e.at e!en :it.e a0ti!e f>n is inferior to t.o>t a fee.e rele!ant risk/free rate. Aor 5 ? #. is t.e .e borro:in= rate.o borro: in ifferent bet:een t. 5o> :o>l fin t.i=. 5-10 ..ese in!estors esire . (+f 5o> sol!e for t. 5o> :o>l nee to pay t.#' < = .e maxim>m feasible fee.at :o>l make in!estors :.) .o are more in0line to borro:) t..#( 7ore risk tolerant in!estors (:. In this range the reward to variability ratio of the index (the passive fund) is better than that of the managed fund.ortfolio. as :e i abo!e for len in= in!estors.e len in= rate.en s on t.at t.en :e noti0e t.assi!e f>n be0a>se= .at is..at f is ne=ati!e. $".e f>n e!en :it. t.e re:ar /to/!ariabilit5 ratio.oose 5o>r a0ti!e f>n . . is !ie:e as t.er ret>rn complete portfolios and thus are in the borrowing range of the relevant CAL. enote f. .em to 0.t.e fee t.erefore :ill not be 0lients of t.2" Aor 5 @ #.o>t a fee.i=.

000 = 13.0593 Therefore.01 x 2 x 17. the increase in the risk premium would require a higher expected rate of return in the equity market. [. In (a) the market risk premium is expected to be lower while the market risk is expected to be at a lower level than in (b). E(rM) − rf = 7.20%.2009 is assumed to be representative of future expected performance.000 + .8).01x2x18. 32. 28. 33.56/18. then y* is given by: y* = 7.40) explains the much smaller proportion invested in equity. Investors perceiving higher risk will demand a higher risk premium to hold the same portfolio they held before. Assuming no change in tastes. The proportion invested in the risky portfolio will depend on the relative change in the expected risk premium (the numerator) compared to the change in the perceived market risk. and σM = 18. 5-11 . If 1993 .6 × 16% + .892)= 1. 66.56%.72% should be allocated to equity and 33.2009 is assumed to be representative of future expected performance.93% of the complete portfolio is allocated to equity and -5. E(rM) − rf = 4.93% to bills.89=0. The expected return of the client's overall portfolio is . 31.4 × 6% = 12%.4 × (−30.000) − 5.000] b a) Curve 2 b) Point F 29. 30. 105. Reward to variability ratio = = = . The expected return of your fund = T-bill rate + risk premium = 6% + 10% = 16%.71. The standard deviation of the client's overall portfolio is .27.74% (we use the standard deviation of the risk premium from the last column of Table 6.74 = 0.6 × 14% = 8.6672 That is. that is.742)= . then y* is given by: y* = = 4. an unchanged risk aversion coefficient. a. and σM = 17. A = 2.28 % to bills.56/(. If we assume that the risk-free rate is unaffected.20/17. A = 2. If 1957 .6 × 50.20/(. The fact that the reward-to-variability ratio is expected to be much lower in (a) (4.4%.89%. the denominator of the equation for the optimal investment in the risky portfolio will be higher. b. A. c.2368) versus 7.

meaning that you are willing to pay quite a risk premium over the expected value of losses.440222) = C252. Without insurance your wealth will then be: Probabilit5 .894. 5A Your $50.%(% 5-12 . your insurance proceeds are only $100.&$4) = #2.439582) = $252.Appendix 1.000) = #2. 2. Your outcome will be: Probabilit5 . If there is a fire. your premium is $100. your investment in the risk-free asset will be only $(50.85 (the certainty equivalent of the uninsured house) results in P = $372.000 C 5'.$$$xlo=e(252.000 – P). C25'.$$$ Wealt.604.06) = $53. This is the most you will be willing to pay for insurance.&$4 Aire Bo fire Expected utility is .06 + 200.85 With fire insurance at a cost of $P.604. With 1/2 coverage.(l2.&$4 C252.78.000 by year end.440222 an W2E = ex. C#52.000) + .00#x)lo=e(5'.$$$ . a.000.000.00# . Note that the expected loss is "only" $200.$$$ x lo=e(25'. The main reason is that the value of the house is a large proportion of your wealth.&$4) + .000 Bo fireAire- which gives expected utility .000 investment will grow to $50. your investment in the safe asset is $49. Setting this expression equal to $252.4'$5&2 and a certainty equivalent wealth of exp(12.00#xlo=e(#52.900 which grows by year end to $52.00# Wealt.000 – P) x 1. Your year-end wealth will be certain (since you are fully insured) and equal to (50.000(1.

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