Tutorial 2

Key Concepts for the Tutorial (These should be read in advance):

(i) Expected Utility and Investor Preferences.
(ii) Holding Period Returns
(iii) Portfolio Diversification and Asset Allocation

1. Consider the following two investments. Which is preferred if the utility

function is U(W) = -W – 0.04W2?

Investment A Investment B
$ Outcome Probability $ Outcome Probability
7 0.4 5 0.5
10 0.2 12 0.25
14 0.4 20 0.25

2. Consider again the table in problem 1. The probability of a $5 payoff is

0.5 and a $12 payoff is 0.25. How much would these probabilities have to
change so that the investor is indifferent between investments A and B?

3. During a period of severe inflation, a bond offered a nominal HPR of

80% per year. The inflation rate was 70% per year.
a. What was the real HPR on the bond over the year?
b. Compare this real HPR to the approximationr ≈ R−i .

4. MCQ - Diversification among assets improves the opportunities faced by

all risk-averse investors
a. irrespective of the correlation coefficients
b. only if correlations are not larger than zero
c. only if the assets have similar variances
d. for assets with relatively large variances
e. none of the above

5. MCQ - If the returns on different assets are uncorrelated

a. an increase in the number of assets in a portfolio may bring the
standard deviation of the portfolio close to zero
b. there will be little gain from diversification
c. diversification will result in risk averaging but not in risk reduction
the expected return on a portfolio of such assets should be zero