Suppose an investor has the following needs and desires: if the returns on his portfolio exceed 25%, he can realize a long-cherished dream and buy a racehorse; if returns are less than 2%, he will starve; and if returns are -100% he goes bankrupt. What are the relevant states of nature for modelling this investor?

Show that an investor with U(w) = w1 1 requires risk premium of = w 2 2 and R = R 2 2 . Discuss how and R change with respect to and w.