Question:

You are considering the following risky portfolio: With equal probabilities, you will receive a cashflow of $100,000 or $170,000 at year-end. There are no other interim payments until the year-end. The alternative risk-free investment in T-bills pays 2% per year.

(a) How much will you be willing to pay for this portfolio, if you require a risk premium of 12%,

(b) Suppose that the portfolio can be purchased for the amount you found in (a). What will be the expected rate of return on the portfolio?

(c) Your circumstances have changed and you now require a risk premium of 16%. What is the price that you will be willing to pay?