You are a civil servant who has a very secure government job paying 36,000 p.a. You are 27 years old and are sure to retire at 70 with a pension paying 40% of you income for another 20 years. Currently your only asset is cash to the value of 100,000 which you inherited from a relative. You consider your optimal investment of this amount into the stock market and cash holding. If you expect the stock market to rise by 8% p.a. with a volatility of 25% p.a. and the risk free rate is 6% p.a., how much would you invest into the stock market? How would this allocation have changed 20 years later, assuming you have not accumulated more financial wealth. How can you explain the difference?

a.Assume an absolute risk aversion of 3.

b. Why do you hedge against the risk in your labor income using the stock market?