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FF Qs & As Topic 5 Part 1 - FEEDBACKFORUM TOPIC5...

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FEEDBACK FORUM TOPIC 5   RISK AND RETURN  PART 1 Question      1     The return and associated probabilities of two assets in each of 3 possible states is given  below. The probabilities are of each state occurring. State I II III Asset A 10% 7% 6% B 5% 8% 9% Probability: 25% 50% 25% The return and variance of assets A and B are:  A) Ra= 7.5; Rb = 7.5; Var A = 1.5; Var B = 1.5  B) Ra= 7.5; Rb = 7.5; Var A = 2.25; Var B = 2.25.  C) Ra= 7; Rb = 7.5; Var A = 2.25; Var B = 2.25.  D) none of the above  ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 n n i PR R PR R PR R R + + + = ..... 2 2 1 1 ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 % 5 . 7 075 . 0 015 . 0 035 . 0 025 . 0 25 . 0 06 . 0 50 . 0 07 . 0 25 . 0 10 . 0 = = + + = + + = A R ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 % 5 . 7 075 . 0 0225 . 0 04 . 0 0125 . 0 25 . 0 09 . 0 50 . 0 08 . 0 25 . 0 05 . 0 = = + + = + + = B R ( 29 ( 29 i i i i PR R R Var 2 - = ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 25 . 0 075 . 0 06 . 0 50 . 0 075 . 0 07 . 0 25 . 0 075 . 0 10 . 0 2 2 2 - + - + - = A Var = 0.00015625+0.0000125+0.00005625 = 0.000225 = 0.0225% ( 29 ( 29 ( 29 ( 29 ( 29 ( 29 25 . 0 075 . 0 09 . 0 50 . 0 075 . 0 08 . 0 25 . 0 075 . 0 05 . 0 2 2 2 - + - + - = B Var = 0.00015625+0.0000125+0.00005625 = 0.000225 = 0.0225% 1
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Question      2       The return and associated probabilities of two assets in each of 3 possible states is given  below. The probabilities are of each state occurring. State I II III Asset  A 10% 7% 6% B 5% 8% 9% Probability: 25% 50% 25% Which asset would a risk averse investor choose?  A) asset A  B) asset B  C) indifferent between A and B  D) depends upon the investor's degree of risk aversion  % 15 . 0 %, 0225 . 0 %, 5 . 7 %, 15 . 0 %, 0225 . 0 %, 5 . 7 = = = = = = B B B A A A Var R Var R σ σ A risk-averse investor will only accept higher risk if there is the possibility of a higher return  (risk-return trade-off). And a rational, risk-averse investor will aim for the highest return for a  given level of risk, or lowest risk for a given return. Therefore, since the expected return for  both Asset A and Asset B is the same and they have the same variance and standard  deviation, a rational, risk-averse investor would be indifferent between the two assets. 2
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Question      3      A risk-averse investor is faced with a selection between Asset A with a standard deviation of  20% and an expected return of 15%, and Asset B with a standard deviation of 25% and an  expected return of 20%. Which asset would the investor prefer?    A) Asset A  B) Asset B  C) depends upon the investor's level of risk aversion  D) indifferent between A and B  % 25 %, 20 %, 20 %, 15 = = = = B B A A R R σ σ Asset B has a higher expected return and  a higher standard deviation. Therefore, Asset B is  riskier than Asset A. However, we cannot answer this question without knowing the investor’s  risk-profile. The investor may be relatively conservative, meaning they would not be prepared 
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