FINC3017 Investments and Portfolio Management Tutorial 2 Solutions Investment Decisions Under Uncertainty

1.

How are different combinations of assets compared when using the concept of utility?

Indifference curves can be used to compare different combinations of assets. Indifference curves are curves drawn where expected utility is held constant and expected return and standard deviation are allowed to change. This curve lists all possible combinations of standard deviation and expected return which yield the same level of utility or alternatively investors are indifferent between all the portfolios which fall on the indifference curve.

2.

How does the level of risk aversion affect the curvature affect the curvature of indifference curves in mean-standard deviation space. If an investor is highly risk averse, more expected return would be required for each unit of additional standard deviation where utility is held constant. Alternatively, the level of return required to compensate each additional unit of risk is greater for the more risk-averse investor. This can be seen from the figure below.
35 30 25 More risk-averse (A=0.06) 20 15 10 5 Less risk-averse (A=0.04)

Mean of Returns (%)

0 0 2 4 6 8 10 12 14 16 18 20 22 24 26 28 30
Standard Deviation of Returns (%)

3.

List two situations where expected returns and standard deviations are sufficient to describe the choice between risky portfolios. Expected return and standard deviation are sufficient to describe the choice between risky portfolios where either the returns are normally distributed or the investor preference function is quadratic.

That is, if returns are normally distributed, then it is not important if investors have a preference for higher moments (such as skewness and kurtosis) as these moments are zero under the normal distribution. However, if investors have a quadratic preference function, then this is equivalent to them being indifferent to higher moments (such as skewness and kurtosis) and hence it will have no bearing on the investors decision making, even if assets have non-zero values for these moments. Under both of these situations only the first two moments are important: expected return (mean) and standard deviation. 4. An individual is questioned about their utility at different levels of wealth. Using this information, what does this imply about the risk preference of this individual? Wealth 10 20 30 U(W) 22 30 34

This individual is a risk-averse individual. As wealth increases, utility increases, but at a decreasing rate 4 (U($30) U($20)) < 8 (U($20) U ($10)). The interpretation is that the increase in utility associated with a rise in wealth from $20 to $30, which is 4 units, is less than the utility experienced from avoiding a decrease in wealth from $20 to $10, which is 8 units. 5. Investment A provides a 40% chance of paying $1000 (good year) and a 60% chance of paying $200 (bad year). Alternatively, investment B has a 50% chance of paying $800 (good year) and a 50% chance of paying $500 (bad year). The pay-off varies across investments and according to the state of the world. Which investment will be preferred if the investor has logarithmic preference functions?

The logarithmic utility form measures the utility of wealth as simply the natural logarithm. The payoff table is shown below. Investment A Investment B Good Year Bad Year Good Year Bad Year 0.4 0.6 0.5 0.5 Probability 1000 200 800 500 Pay Off 5.30 6.68 6.21 Natural Log of Payoff 6.91 2.76 3.18 3.34 3.11 Weighted Pay-Off 5.94 6.45 Expected Utility Investment B is preferred.