Question

Assume a risky asset has a mean return of µS = 0.05 and volatility of σS = 0.1 and the risk-free asset has a mean return of 0.02. When you work up this morning you had a risk aversion of α = 2, but after reading the news paper you were worried that we were entering a recession and your risk aversion increased to α = 10. Based on the optimal portfolio allocation setting where you have one risky asset and one risk-free asset, what would be the change in your optimal portfolio weight on the risky asset from this change in risk aversion?

A) 1.2

B) 0.6

C) 0.06

D) −0.6

E) None of the above

Answer 1

Weight of risky asset on optimal portfolio=(returns of risky asset-risk free rate)/(A*standard deviation of risky asset^2)

Change=(5%-2%)/(10*0.1^2)-(5%-2%)/(2*0.1^2)=-1.2000