Q1

a) The more wealth we have the more our utility grows - it growth exponentially – I think It
does not make sense because it would mean that there is no celling for our utility and it
could growth to infinity and negative wealth (debt) would give an investor a positive utility
(it is squared).
b) The more wealth we acquired the less utility we have – It does not make sense because it
implies that our wealth can’t be 0, having a fraction of a unit would give us a near infinite
utility (the smaller the fraction) and it is contradictory – more wealth should not give us
smaller utility (unless we are an ascetic).
c) The more leveraged (negative wealth) the investor is the more utility it has for him – highly
unlikely, unless the investor is Bill Hwang.
d) This make sense – linear relation between utility and wealth.
e) This is very much reasonable – the highest probability that an investor will have such a utility
function. Diminishing marginal utility – If we are starving 10$ can save our live but for a
millionaire it does not matter at all.
f) The combination of b) and c) so it also does not make sense – positive wealth should not
give negative utility.

Q2

a) Each investor is risk averse (A>0) so they will choose portfolio with the highest sharpe
ratio. It means they will choose portfolio that gives them the highest risk adjusted return
on a unit of risk (I will skip risk free rate part because it is not given) – They will choose
portfolio A.
b) Ua = 20% - 0,5*0,04 = 18%
Ub = 12% - 0,5*0,0484 = 9,58%
Uc = 15% - 0,5*0,0784 = 11,08%
c) 12% - 0,5(A)*0,0484 - 15% + 0,5(A)*0,0784 = 0
0,015(A) = 3%
A=2

Q3

a) E(r) = 0,33 * (12% + 17% + 7%) = 11,88%

b) Var = 0,332 (0,0625 + 0,09 + 0,04) + 2*0,332*0,5*0,0625*0,09 + 2*0,332*0,25*0,0625*0,04+
2*0,332*0,35*0,09*0,04 = 0,022
Std(p) = 14,83%
Vs.
Std(a) = 25%
c) E(rp) = 11,88%, std(p) = 14,83%
E(r2) = 12%, std(2) = 30%
Investor would choose equally weighted portfolio (the higher A the more risk averse the
investor is)
d) Still he would choose equally weighted portfolio
e) Cov(1+2+3, 1+3) = Var(1) + Cov(1,3) + Cov(2,1) + Cov(3,1) + Var(3) = Var(1) + Var(3) +
2*p(1,3)*std(1)*std(3) + p(2,1)*std(1)*std(2) = 16,5%
Q4

a)
b)
c)

Q5

a) E(P) = 0,5*14,71% +0,5*16,12% = 15,415 %

E(Q) = 0,334 * (18,99% + 24,01% + 21,17%) = 21,4328%
b) Cov(A,B) = 250

Var = 0,332*(900+1600+1225)+2*0,332*240 + 2*0,332*490 + 2*0,332*577,5 = 690,426

Chapter 6:

4.

a) E = 0,5*70 000 + 0,5*200 000 = 135 000

8% = E(r) – 6% --> E(r) = 14%

135 000/(1,14) = 118 421

c) E = 0,5*70 000 + 0,5*200 000 = 135 000

The expected rate of return will be 14%
d) E(r) = 18%
 135 000/(1,18) = 114 406

d) The higher required risk premium the more risk averse the investor is and the more return
he will demand, that is, he will be willing to pay less for the same return.

6.

7. Investor with A=4 is more risk averse

13. E(r) = 18%

Std = 28%

T-bill = 8%

E(rp) = 0,7*18% + 0,3*8% = 15%

Var(p) = 0,7*0,28 = 19,6%