Question

1. If an investor borrows money to invest in risky portfolio, where will the combination portfolio (the leveraged portfolio) be positioned?

a. Above the CAL

b. Below the CAL

c. On the CAL to the left of risky portfolio

d. On the CAL to the right of risky portfolio

2. An investor’s utility function for expected return and risk is U = E(r)−4σ^2. Which of the following would this investor prefer to invest in?

a. a risk-free security offering a return of 8 percent per year

b. a risky portfolio with expected return of 14 percent per year and standard deviation of 25 percent per year

3. Cathy Chu has $10,000 in a savings account that guarantees her a return of 5% per year. Cathy was offered an investment opportunity that has an expected return of 5% but possible returns range from −30% to 40%. Cathy declined the investment opportunity in favor of her savings account. Cathy is

a. risk adverse

b. risk avoider

c. risk intolerant

d. risk averse

Answer 1

Q1) D) On the CAL, to the right of risky portfolio

Explanation: As per Capital allocation line , when you borrow money to invest , it fall on the right of the risky portfolio on CAL because you take more risk when you invest,where as when you lend it falls on the left hand side of the risky portfolio on CAL because you take less risk when you lend as you know the interest rate that you will receive.

Q2) A) a risk free security offering a return of 8% per year

Reason : in option b) expected return = 14% and standard deviation = 25%

Putting it in the utility function

U = E(r) - 4 standard deviation^2

= 0.14 - 4 ( 0.25)^2

= 0.14 - 4 ( 0.0625 )

= 0.14 - 0.25

= -0.09 or - 9%

This is less than the risk free return.

Q3) D) Risk Averse

Explanation: A risk averse is an investor who prefers a low return with known risk rather than a higher return with unknown or uncertain risk . In this case, one option is guaranteed 5% return with risk being known as the return is guaranteed. As in the second option their is no certainty that you will get 5% as their is a range between which it will vary. This feature perfectly matches with that of risk averse investor.