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Chapter 2: Q5C. (page 144)

Use the following data in answering CFA Questions:

Investor “satisfaction” with portfolio increases with expected return and decreases with variance according to the “utility” formula: U = E(r) - ½ Aσ2where A = 4.

Question: Based on the formula above, which investment would you select if you were risk neutral?

Short Answer

Expert verified

The correct answer is Investment 4.

Step by step solution

01

Given information

“Utility” formula: U = E(r) - ½ Aσ2 where A = 0.

In the Utility formula, the A represents risk aversion of the investor. The higher the value of A, the more risk averse the investor will be.

02

Solution/Explanation

As an investor, if I am risk neutral, the value of A = 0.

In this case, the portfolio with the highest utility would be the portfolio with highest expected return.

Since the highest expected return is of Investment 4, therefore, the correct answer is Investment 4.

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Most popular questions from this chapter

The security market line depicts:

a. A security’s expected return as a function of its systematic risk.

b. The market portfolio as the optimal portfolio of risky securities.

c. The relationship between a security’s return and the return on an index.

d. The complete portfolio as a combination of the market portfolio and the risk-free asset.

If the simple CAPM is valid, which of the situations in Problems 13 – 19 below are possible? Explain. Consider each situation independently.

Use the following data in answering CFA Questions:

Investor “satisfaction” with portfolio increases with expected return and decreases with variance according to the “utility” formula: U = E(r) - ½ Aσ2where A = 4.

Question: The variable ( A ) in the utility formula represents the:

a. Investor’s return requirement.

b. Investor’s aversion to risk.

c. Certainty equivalent rate of the portfolio.

d. Preference for one unit of return per four units of risk.

You know that firm XYZ is very poorly run. On a scale of 1 (worst) to 10 (best), you would give it a score of 3. The market consensus evaluation is that the management score is only 2. Should you buy or sell the stock?

You are a consultant to a large manufacturing corporation considering a project with the following net after-tax cash flows (in millions of dollars):

YEARS FROM NOWAfter-Tax CF
0
1-9
10		-20
10
20

The project’s beta is 1.7. Assuming r f = 9% and E ( r M ) = 19%, what is the net present value of the project? What is the highest possible beta estimate for the project before its NPV becomes negative?
See all solutions

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