Question

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.

Short answer

The correct answer is b.

Step-by-step solution

Given information

“Utility” formula: U = E(r) - ½ Aσ² where A = 4.

Solution/Explanation

The term risk aversion refers to the stated position of an investor who is not open to risk taking unless it is commensurate with expected returns.

In the utility formulae, the ‘A’ denotes investor’s risk aversion. In other words, it would mean that a highly risk averse investor would not invest in a portfolio with a high ‘A’ value.

Therefore the correct answer is option b.