investment chapter6(5)

Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

70. Toby and Hannah are two risk-averse investors. Toby is more risk-averse than Hannah. Draw one indifference curve for Toby and one indifference curve for Hannah on the same graph. Show how these curves illustrate their relative levels of risk aversion.

71. Discuss the characteristics of indifference curves, and the theoretical value of these curves in the portfolio building process.

72. Describe how an investor may combine a risk-free asset and one risky asset in order to obtain the optimal portfolio for that investor.

73. The optimal proportion of the risky asset in the complete portfolio is given by the equation y * = [E(rP)-rf]/(.01A * Variance of P). For each of the variables on the right side of the equation, discuss the impact of the variable's effect on y* and why the nature of the relationship makes sense intuitively. Assume the investor is risk averse.

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

74. You are evaluating two investment alternatives. One is a passive market portfolio with an expected return of 10% and a standard deviation of 16%. The other is a fund that is actively managed by your broker. This fund has an expected return of 15% and a standard deviation of 20%. The risk-free rate is currently 7%. Answer the questions below based on this information. a. What is the slope of the Capital Market Line?

b. What is the slope of the Capital Allocation Line offered by your broker's fund? c. Draw the CML and the CAL on one graph.

d. What is the maximum fee your broker could charge and still leave you as well off as if you had invested in the passive market fund? (Assume that the fee would be a percentage of the investment in the broker's fund, and would be deducted at the end of the year.)

e. How would it affect the graph if the broker were to charge the full amount of the fee?

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

Chapter 06 Risk Aversion and Capital Allocation to Risky Assets Answer Key

Multiple Choice Questions

1. Which of the following statements regarding risk-averse investors is true? A. They only care about the rate of return.

B. They accept investments that are fair games.

C. They only accept risky investments that offer risk premiums over the risk-free rate. D. They are willing to accept lower returns and high risk.

E. They only care about the rate of return and accept investments that are fair games. Risk-averse investors only accept risky investments that offer risk premiums over the risk-free rate.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Risk Aversion

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

2. Which of the following statements is (are) true?

I) Risk-averse investors reject investments that are fair games.

II) Risk-neutral investors judge risky investments only by the expected returns. III) Risk-averse investors judge investments only by their riskiness. IV) Risk-loving investors will not engage in fair games. A. I only B. II only

C. I and II only D. II and III only E. II, III, and IV only

Risk-averse investors consider a risky investment only if the investment offers a risk premium. Risk-neutral investors look only at expected returns when making an investment decision.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Risk Aversion

3. Which of the following statements is (are) false?

I) Risk-averse investors reject investments that are fair games.

II) Risk-neutral investors judge risky investments only by the expected returns. III) Risk-averse investors judge investments only by their riskiness. IV) Risk-loving investors will not engage in fair games. A. I only B. II only

C. I and II only D. II and III only E. III, and IV only

Risk-averse investors consider a risky investment only if the investment offers a risk premium. Risk-neutral investors look only at expected returns when making an investment decision.

AACSB: Analytic Bloom's: Remember Difficulty: Intermediate Topic: Risk Aversion

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Chapter 06 - Risk Aversion and Capital Allocation to Risky Assets

4. In the mean-standard deviation graph an indifference curve has a ________ slope. A. negative B. zero C. positive D. northeast

E. cannot be determined

The risk-return trade-off is one in which greater risk is taken if greater returns can be expected, resulting in a positive slope.

AACSB: Analytic Bloom's: Remember Difficulty: Basic

Topic: Risk Tolerance

5. In the mean-standard deviation graph, which one of the following statements is true regarding the indifference curve of a risk-averse investor?

A. It is the locus of portfolios that have the same expected rates of return and different standard deviations.

B. It is the locus of portfolios that have the same standard deviations and different rates of return.

C. It is the locus of portfolios that offer the same utility according to returns and standard deviations.

D. It connects portfolios that offer increasing utilities according to returns and standard deviations.

E. It is irrelevant to making a decision of what portfolio would best suit the investor. Indifference curves plot trade-off alternatives that provide equal utility to the individual (in this case, the trade-offs are the risk-return characteristics of the portfolios).

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