13. Risky Assets - Solutions

13. Risky Assets - Solutions - Chapter 13 NAME Risky Assets...

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Chapter 13 NAME Risky Assets Introduction. Here you will solve the problems of consumers who wish to divide their wealth optimally between a risky asset and a safe asset. The expected rate of return on a portfolio is just a weighted average of the rate of return on the safe asset and the expected rate of return on the risky asset, where the weights are the fractions of the consumer’s wealth held in each. The standard deviation of the portfolio return is just the standard deviation of the return on the risky asset times the fraction of the consumer’s wealth held in the risky asset. Sometimes you will look at the problem of a consumer who has preferences over the expected return and the risk of her portfolio and who faces a budget constraint. Since a consumer can always put all of her wealth in the safe asset, one point on this budget constraint will be the combination of the safe rate of return and no risk (zero standard deviation). Now as the consumer puts x percent of her wealth into the risky asset, she gains on that amount the diFerence between the expected rate of return for the risky asset and the rate of return on the safe asset. But she also absorbs some risk. So the slope of the budget line will be the diFerence between the two returns divided by the standard deviation of the portfolio that has x percent of the consumer’s wealth invested in the risky asset. You can then apply the usual indiFerence curve–budget line analysis to ±nd the consumer’s optimal choice of risk and expected return given her preferences. (Remember that if the standard deviation is plotted on the horizontal axis and if less risk is preferred to more, the better bundles will lie to the northwest.) You will also be asked to apply the result from the Capital Asset Pricing Model that the expected rate of return on any asset is equal to the sum of the risk-free rate of return plus the risk adjustment.
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13. Risky Assets - Solutions - Chapter 13 NAME Risky Assets...

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