Question 2:

Assuming that the end-of-year cash flow derived from a risky portfolio, will be, with equal probability, either $84,000 or $240,000. The rate of return on a Treasury security is 7.2% per year.

a. How much would you be willing to pay for this portfolio if you require a risk premium of 9.6%. Determine the expected rate of return of this risky portfolio.

b. How much would you be willing to pay for this portfolio if now you require a risk premium of 14.4%. Explain in what kind of economic condition(s), you would require a higher risk premium compare to the case in (a). Determine the expected rate of return of this risky portfolio.

c. Provide a write-up on the conclusion about the relationship between the required risk premium, expected rate of return and the price of the risky portfolio. You may wish to compare your answers in (a) and (b) to support your discussion.