Student Name: Akash Sharma

Student ID: 2221014

Date: November 9, 2022

APT - I
Assignment 2

Problem 1

For an individual with a negative exponential utility function, u(w) = −e(−bw) calculate the optimum

share of wealth invested in risky assets (A∗ ).

Additionally, explain how the value of A∗ varies with

(a) Initial Level of Wealth, w0 .

(b) Measure of Absolute Risk Aversion, b.

Solution: Consider a single period environment for an individual such that,

rf = Risk-Free Rate

r̃ = Return on Risky Security

w0 = Initial Wealth

A = Amount Invested in Risky Security

w0 − A = Amount Invested in Risk-Free Security

u(w) = Utility for a given wealth-level = −e(−bw)

w̃ = Wealth at the end of the Period = w0 (1 + rf ) + A(r̃ − rf )

Now for the individual with such preferences and endowment, the objective here is to maximize the

utility that the individual derives from their wealth at the end of the period. That is,
 
Objective Function: max E u(w̃)
A

So given the utility function for the individual, and the final wealth level at the end of the period,

the expected utility that the individual would derive from this wealth would be,

   
−b{w0 (1+rf )+A(r̃−rf )}
E u(w̃) = E − e
 
−bw0 (1+rf ) −bA(r̃−rf )
=E −e ·e
   
−bA(r̃−rf ) −bw0 (1+rf )
=E e · −e
Suppose us = e−bw0 (1+rf ) , is the utility derived from the wealth invested in risk-free assets.

And also,

Suppose r̃e = r̃ − rf is the excess return earned from the risky asset.

So, the Expected Utility at the end of the period becomes,

 
E u(w̃) = − us · E e−bAr̃e
 
(1)

Which is what we are trying to maximize, by choosing the optimum value of A = A∗ .

Now assuming that the excess returns on risky assets, i.e. r̃e = r̃ − rf has a normal distribution

=⇒ r̃e ∼ N (µ, σ 2 ).

=⇒ −bAr̃e ∼ N (−bAµ, b2 A2 σ 2 ).

=⇒ e−bAr̃e follows a log-normal distribution.

b2 A 2 σ 2
=⇒ E e−bAr̃e = e−bAµ+ 2
 
(2)

Now using the expected value of utility from the wealth invested in risky assets from (2) in the equation

for the expected value of utility from the total invested wealth (1), we get,

 
= − us · E e−bAr̃e
 
E u(w̃)

b2 A2 σ 2
=⇒ u(w) = − e−bw0 (1+rf ) · e−bAµ+ 2

So, the optimization problem now becomes,

 
2 2 2
−bw0 (1+rf ) −bAµ+ b A2 σ
 
max E u(w̃) ≡ max u(w) ≡ max − e ·e
A A A

b2 A2 σ 2
 
Which is the same as maximizing the value of f (A) = bAµ −
2
For maximizing, f (A), for the First-Order-Condition, differentiating w.r.t. A, we get,

 
d
f (A) = bµ − b2 Aσ 2 = b(µ − bAσ 2 )
dA

For the F.O.C. with f ′ (A) = 0, with b ̸= 0, we get, A = µ/bσ 2

µ
∴ A∗ = (3)
bσ 2