Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to select one of three prospective investments: X, Y, and Z. Assume that the measure of risk Sharon cares about is an asset's standard deviation. The expected returns and standard deviations of the investments are as follows: a. If Sharon were risk neutral, which investment would she select? Explain why. b. If she were risk averse, which investment would she select? Why? c. If she were risk seeking, which investments would she select? Why? d. Suppose a fourth investment, W, is available. It offers an expected return of 14%, and it has a standard deviation of 9%. If Sharon is risk averse, can you say which investment she will choose? Why or why not? Are there any investments that you are certain she will not choose? Investment X Y Expected return 13% 13% 13% Standard deviation 7% 8% 9% a. If Sharon were risk neutral, which investment might she select? (Choose all that apply.) A. Investment Z. B. Investment X C. Investment Y D. None of the three investments. b. If she were risk averse, which investment might she select? (Select the best answer below.) O A. Investment Y. B. Investment Z. C. Investment X. D. None of the three investments. c. If she were risk seeking, which investments might she select? (Select the best answer below.) A. Investment X B. Investment Z. C. None of the three investments. D. Investment Y. d. Suppose a fourth investment, W, is available. It offers an expected return of 15%, and it has a standard deviation of 9%. If Sharon is risk averse, can you say which investment she will choose? Why or why not? Are there any investments that you are certain she will not choose? (Select the best answer below.) A. If Sharon were risk averse, it is not clear whether she would prefer investment W or X. From part (b), Sharon prefers X to Y and Z, but investment W has a lower expected return and standard deviation. Thus, Sharon's preference between Wand X will depend on whether the return expected on W is sufficient compensation for the extra investment. In other words, Sharon's choice will depend on her risk tolerance (i.e, her degree of risk aversion). B. If Sharon were risk averse, it is not clear whether she would prefer investment W or X. From part (b), Sharon prefers X to Y and Z, but investment W has a higher expected return and standard deviation. Thus, Sharon's preference between W and X will depend on whether the extra return expected on W is sufficient compensation for the extra risk. In other words, Sharon's choice will depend on her risk tolerance (i.e, her degree of risk aversion). O c. If Sharon were risk averse, it is not clear whether she would prefer investment W or Z. From part (b), Sharon prefers Z to X and Y, but investment W has a higher expected return and standard deviation. Thus, Sharon's preference between W and Z will depend on whether the extra return expected on W is sufficient compensation for the extra risk. In other words, Sharon's choice will depend on her risk tolerance (i.e, her degree of risk aversion). D. If Sharon were risk averse, it is not clear whether she would prefer investment W or Y. From part (b), Sharon prefers Y to X and Z, but investment W has a higher expected return and standard deviation. Thus, Sharon's preference between W and Y will depend on whether the extra return expected on W is sufficient compensation for the extra risk. In other words, Sharon's choice will depend on her risk tolerance (i.e, her degree of risk aversion)
