(a) Compute the expected return on the risk-free (1) investment. Risk Tolerance: Understanding the trade-off Example (cont'd) between Risk and Return . Suppose an investor has $50,000 to invest and tries to allocate money between a risky and a risk-free investment. The risky investment will either halve or double, with equal probability: Payoff diagram: (b) Compute the expected return on the risky investment. only 1 90,00 - rf=3%. Possible. 2 Possibilities. 20 ProdProd 1 Example (cont'd) . Compute the risk premium or expected excess return on the risky investment Definition: The excess return is defined as the return net of the risk-free rate -> RP, = E(n)-) Measure of Risk The measure of risk we will use for now is the return variance or standard deviation, the two are equivalent - For the risk-free asset, the variance is zero. . For the risky investment the return variance is: * If asset returns are normally distributed, SD is a complete measure of (see Assumption on p6)