Question
Suppose that you use a quadratic utility function, U = E(r) 1 2A2 , to make your financial decisions. The average historical return for large
Suppose that you use a quadratic utility function, U = E(r) 1 2A2 , 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%
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