Answered step by step
Verified Expert Solution
Link Copied!

Question

1 Approved Answer

Consider an investor with preferences over the mean and variance of the returns on his or her portfolio that are described by the utility

Consider an investor with preferences over the mean and variance of the returns on his or her portfolio that

Consider an investor with preferences over the mean and variance of the returns on his or her portfolio that are described by the utility function U(@P,0})=HP- (4) , where a higher value of A corresponds to a larger aversion to risk. Suppose that this investor is able to form a portfolio from a risk-free asset with return rf and a risky asset with expected return equal top, and a standard deviation of its return equal to or. In this context, the risky asset may simply be the only risky asset available to the investor or it can be the tangency portfolio that represents the optimal combination of many individual risky assets. Either way, our analysis from class showed that the relationship between up and op for the portfolio that combines the risk-free asset with the risky asset is linear: + (# = 71) Or - Tf Or HP = Tf+ By substituting this constraint into the investor's utility function, his or her problem can be solved as one of choosing op to maximize Tf+ op. Op- - ( 4 ) %. Use the first-order condition for this problem to solve for the optimal choice of op. Our analysis from class also showed that the portfolio formed from the risk-free and risky asset that has a return with standard deviation op allocates the fraction op of wealth to the risk asset and the remaining fraction 1- w to the risk-free asset. Use this expression, together with your solution for the optimal choice of op from question 3, above, to find the investors' optimal choice of w. How does the optimal share of the risky asset depend on the investor's risk aversion, as measured by the parameter A from the utility function? How does the optimal share of the risky asset depend on r-rf, the risk premium defined as the expected return on the risky asset minus the risk-free return?

Step by Step Solution

There are 3 Steps involved in it

Step: 1

Answer To find the optimal choice of P we need to maximize the utility function UP P2 P A2 P2 subject to the constraint P rf r rfr P Lets differentiate the utility function with respect to P and set i... blur-text-image

Get Instant Access to Expert-Tailored Solutions

See step-by-step solutions with expert insights and AI powered tools for academic success

Step: 2

blur-text-image

Step: 3

blur-text-image

Ace Your Homework with AI

Get the answers you need in no time with our AI-driven, step-by-step assistance

Get Started

Recommended Textbook for

Microeconomics An Intuitive Approach with Calculus

Authors: Thomas Nechyba

1st edition

538453257, 978-0538453257

More Books

Students also viewed these Finance questions

Question

Describe the approach for process design.

Answered: 1 week ago