CHAPTER 6: RISK AND RISK AVERSION

1. a. The expected cash flow is: (0.5 × $70,000) + (0.5 × 200,000) = $135,000
With a risk premium of 8% over the risk-free rate of 6%, the required rate of
return is 14%. Therefore, the present value of the portfolio is:
$135,000/1.14 = $118,421

b. If the portfolio is purchased for $118,421, and provides an expected cash

inflow of $135,000, then the expected rate of return [E(r)] is derived as
follows:
$118,421 × [1 + E(r)] = $135,000
Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate
or return with the required rate of return.

c. If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$135,000/1.18 = $114,407

d. For a given expected cash flow, portfolios that command greater risk premia
must sell at lower prices. The extra discount from expected value is a penalty
for risk.

2. When we specify utility by U = E(r) – 0.005Aσ 2 , the utility level for T-bills is 7%.
The utility level for the risky portfolio is: U = 12 – 0.005A × 182 = 12 – 1.62A
In order for the risky portfolio to be preferred to bills, the following inequality must
hold:
12 – 1.62A > 7 ⇒ A < 5/1.62 = 3.09
A must be less than 3.09 for the risky portfolio to be preferred to bills.

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3. Points on the curve are derived by solving for E(r) in the following equation:
U = 5 = E(r) – 0.005Aσ 2 = E(r) – 0.015σ 2
The values of E(r), given the values of σ 2 , are therefore:
σ σ2 E(r)
0% 0 5.000%
5% 25 5.375%
10% 100 6.500%
15% 225 8.375%
20% 400 11.000%
25% 625 14.375%

The bold line in the following graph (labeled Q3, for Question 3) depicts the
indifference curve.

E(r) U(Q4,A=4)
U(Q3,A=3)

5
U(Q5,A=0)
4

σ
U(Q6,A<0)

4. Repeating the analysis in Problem 3, utility is now:

U = E(r) – 0.005Aσ 2 = E(r) – 0.020σ 2 = 4
The equal-utility combinations of expected return and standard deviation are
presented in the table below. The indifference curve is the upward sloping line in
the graph above, labeled Q4 (for Question 4).

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 σ σ2 E(r)
0% 0 4.000%
5% 25 4.500%
10% 100 6.000%
15% 225 8.500%
20% 400 12.000%
25% 625 16.500%
The indifference curve in Problem 4 differs from that in Problem 3 in both slope and
intercept. When A increases from 3 to 4, the increased risk aversion results in a greater
slope for the indifference curve since more expected return is needed in order to
compensate for additional σ. The lower level of utility assumed for Problem 4 (4%
rather than 5%) shifts the vertical intercept down by 1%.

5. The coefficient of risk aversion for a risk neutral investor is zero. Therefore, the
corresponding utility is equal to the portfolio’s expected return. The corresponding
indifference curve in the expected return-standard deviation plane is a horizontal
line, labeled Q5 in the graph above (see Problem 3).

6. A risk lover, rather than penalizing portfolio utility to account for risk, derives greater
utility as variance increases. This amounts to a negative coefficient of risk aversion.
The corresponding indifference curve is downward sloping in the graph above (see
Problem 3), and is labeled Q6.

7. c [Utility for each portfolio = E(r) – 0.005 × 4 × σ 2

We choose the portfolio with the highest utility value.]

8. d [When investors are risk neutral, then A = 0; the portfolio with the highest
utility is the one with the highest expected return.]

9. b

10. The portfolio expected return and variance are computed as follows:
rPortfolio
(1) (2) (3) (4) σPortfolio
(1)× (2)+(3)× (4 σ 2Portfolio
WBills rBills WIndex rIndex (3) × 20%
)
0.0 5% 1.0 13.5% 13.5% 20% 400

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 0.2 5% 0.8 13.5% 11.8% 16% 256
0.4 5% 0.6 13.5% 10.1% 12% 144
0.6 5% 0.4 13.5% 8.4% 8% 64
0.8 5% 0.2 13.5% 6.7% 4% 16
1.0 5% 0.0 13.5% 5.0% 0% 0

11. Computing utility from U = E(r) – 0.005 × Aσ 2 = E(r) – 0.015σ 2 , we arrive at the
values in the column labeled U(A = 3) in the following table:

WBills WIndex rPortfolio σPortfolio σ 2Portfolio U(A = 3) U(A = 5)

0.0 1.0 13.5% 20% 400 7.50 3.50
0.2 0.8 11.8% 16% 256 7.96 5.40
0.4 0.6 10.1% 12% 144 7.94 6.50
0.6 0.4 8.4% 8% 64 7.44 6.80
0.8 0.2 6.7% 4% 16 6.46 6.30
1.0 0.0 5.0% 0% 0 5.00 5.00
The column labeled U(A = 3) implies that investors with A = 3 prefer a portfolio
that is invested 80% in the market index and 20% in T-bills to any of the other
portfolios in the table.

12. The column labeled U(A = 5) in the table above is computed from:
U = E(r) – 0.005 Aσ 2 = E(r) – 0.025σ 2
The more risk averse investors prefer the portfolio that is invested 40% in the
market index, rather than the 80% market weight preferred by investors with A = 3.

13. Sugarcane is now less useful as a hedge. The probability distribution is as follows:
Normal Year for Sugar Abnormal Year
Bullish Stock Bearish Stock
Market Market
Probability 0.5 0.3 0.2
Stock
Best Candy 25.0% 10.0% −25.0%
Sugarcane 10.0% −5.0% 20.0%
Humanex’s Portfolio 17.5% 2.5% −2.5%
Using the distribution of portfolio rate of return, the expected return and standard
deviation are calculated as follows:
E(r p) = (0.5 × 17.5) + (0.3 × 2.5) + [0.2 × (–2.5)] = 9.0%
σ p = [0.5 × (17.5 – 9) 2 + 0.3 × (2.5 – 9) 2 + [0.2 × (–2.5 – 9) 2] 1/2 = 8.67%
While the expected return has improved somewhat, the standard deviation is now

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significantly greater, and only marginally better than investing half of the portfolio
in T-bills.

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14. The expected return for Best Candy is 10.5% and the standard deviation is 18.9%.
The mean and standard deviation for Sugarcane are now:
E(r) = (0.5 × 10) + [0.3 × (–5)] + (0.2 × 20) = 7.5%
σ = [ 0.5 × (10 – 7.5) 2 – 0.3 × (–5 – 7.5) 2 + 0.2 × (20 – 7.5) 2] 1/2 = 9.01%
The covariance between Best Candy and Sugarcane is:
Cov(rBest , rCane ) =
[0.5(25 – 10.5)(10 – 7.5)] + [0.3(10 – 10.5)(–5 – 7.5)] + [0.2(–25 – 10.5)(20 –7.5)] = –68.75

15. Using the results from Problem 14, the portfolio expected rate of return is
computed as follows:
E(rp) = (0.5 × 10.5) + (0.5 × 7.5) = 9%

We can use Rule 5 to compute the portfolio standard deviation as follows:

σP = [ w 2B σ2B + w C2 σC2 + 2 w B w C Cov (rB , rC )]1 / 2

= [(0.52 × 18.92) + (0.52 × 9.012) + (2 × 0.5 × 0.5 × (–68.75))]1/2 = 8.67%

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