Part 1: Preferences and the Equity Premium Puzzle

Suppose that you use a quadratic utility function, U = E(r) 12 A2, to make your financial decisions. The average historical return for large US stocks is 11.63% with a standard deviation of 20.56%. Suppose that you also use this for your estimates of E(r) and .

1. Suppose that in choosing a portfolio consisting of a risk-free asset (where rf = 3%) and large US stocks, you invest 60% of your money in large US stocks (and the rest in the risk-free asset). What does this imply about your risk aversion coefficient, A?

2. If your preferences are consistent (i.e. you use the same utility function, including the same A as above), which would you prefer? (a) an asset which has E(r)=5% and =0 (b) an asset with E(r) = 10% and = 20% Assume that you are only investing in (a) or (b) and not mixing the two assets into a portfolio.