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with the principle of maximum expected return, rather than with that of expected utility. When satises the axioms of rationality, continuity and independence of non-relevant alternatives can be represented by a utility function with the expected utility form. Von Neuman and Morgestern Utility is when rational agents do not maximise expected money, they maximise expected utility of money. Therefore the statement is false. It is possible to represent preferences of rational individuals under uncertainty in terms of VN& M utility functions under the axioms of choice under uncertainty and when agents prefer more to less, the marginal utility is positive: Completeness, i.e. given two choices an individual can say which one he/she prefers or that he/she is indifferent between the two Transitivity (If x is preferred to y, and y is preferred to z, then it must be that x is also preferred to z. Formally: if x y and y z, then x z. Same with indifference) Independence of irrelevant alternatives Measurability Ranking

U(W2)

The graph below will further explain this statement through comparison between risk-averse and riskneutral individual.

E [U(W2) + U(W1)]

Note that the blue line depicts the utility function for risk-averse individual and the red line is for the risk-neutral person. The VN&M says that a rational investor maximises the expected utility, E[U(W)]. On the diagram, E [U(W2) + U(W1)] is the value of a maximum expected utility. This utility is the same for both risk-averse and risk-neutral investors.

U(W1)

W1

W0

E(W1 + W2)

W2

Return, W

The expected utility E [U(W2) + U(W1)] corresponds to expected return E(W1 + W2) in the red line, point A . Maximising expected utility is the same as maximising expected return for risk-neutral person. At point B, for risk-averse individual, the value of expected utility corresponds to a return of w0 which is below the expected return, E(W1 + W2). Risk-neutral investors decision based on maximising expected utility will at the same time maximise the expected return. 1

QUESTION 2

[()] = ( )

110 2

The V&NM utility function implies that the expected utility for Lottery A: Given the utility function U(X)=( = 145 So, [()] = 145

5 9 2 ) , 10

[()]=0.5 10 + 0.5 10

90

130 2

A person is indifferent means that he gains the same expected utility for lottery A and B. 145= ( )2 + (1 )(

10 150 2 ) 10

Utility vs Return

400 300 200 100 0 -3000 -2000 -1000 -100 -200 -300 -400 -500 -600 -700 0 1000 2000 3000 4000 5000 6000 7000 8000 9000 10000

Utility

Return ($)

b) The return of $2000 would give the investor $5000 or nothing with equal chances. Assuming his utility function as a VN&M utility, we can find his expected utility of the return, E[U(X)]. Return, 0 5000 Utility, U( ) 0 280 Probability, 0.5 0.5

Taking return as a present value, the expected utility: [()] = ( ) = 0.5 (0) + 0.5 (280) = 140 The investment would give him the expected utility of 140. The opportunity cost of executing the investment is his personal consumption. If the investor decides not to invest and use that $2000 for his personal consumption, he would enjoy a greater utility of 150. So, the investor will not be willing to execute this investment. c) The project would yields $1000 or $10000 with equal probabilities. Return, 1000 10000 Utility, U( ) 80 340 Probability, 0.5 0.5

The expected utility: [()] = ( ) = 0.5 (80) + 0.5 (340) = 210 The expected utility of the project is 210. He would be willing to invest any amount of money that makes him worse off if he did not take the investment. So, the maximum amount of investment is $3000 because this amount gives him utility of 210. Any amount below $3000 that gives him utility less than 210 would make him better off by taking the project. For example, the consumption of $2000 gives him utility of 150; instead if he invests $2000, the expected utility is 210. He would rather invest in this case. Any amount over $3000 would make him better off to spend rather than invest. For example, $4000 would give him utility of 250 but if he uses that money for investment, the expected utility is only 210. He would rather consume $4000.

300 U(5000) = 280

Utility

200

U= 140

5000

Return ($)

The blue line is the utility function for the investor. The red line is the expected utility of the return from the investment that yields $5000 or nothing with equal probability. For any return, if the blue line is above the red line, the investor will gain more utility by consuming the money instead of undertaking the investment. For return that the blue line is below the red line, the investor should use the money to take the investment instead of using it for his personal consumption. At $2000, the blue line is above the red line and he gain more utility by consuming rather than investing. For part (c),

400

Utility

U= 210

100 U(1000) = 80

10000

Return ($)

The blue line is the utility function for the investor. The red line is the expected utility of the return from the investment that probably yields $10000 or $1000. The expected utility can be found as at $1000, he gains 80 and at $10000, he gains 340. The expected utility then becomes 210. The maximum amount of investment can be found from the intersection of blue and red line, at $3000. 4

QUESTION 4 a)

Expected return on Stock A, = = (-0.02 x 0.05) + (-0.01 x 0.15) + (0.15 x 0.60) + (0.15 x 0.20) = 0.1175 = 11.75% Expected return on Stock B, = = (-0.2 x 0.05) + (-0.1 x 0.15) + (0.15 x 0.60) + (0.30 x 0.20) = 0.125 = 12.5%

2 Variance for A, = ( )2 = 0.05 (0.1175 + 0.02)2 + 0.15 (0.1175+0.01)2 + 0.60 (0.15 0.1175)2 + 0.2(0.15 0.1175)2 = 0.004229

2 Variance for B, = ( )2 = 0.05 (0.125 + 0.20)2 + 0.15 (0.125 + 0.10)2 + 0.60 (0.15 0.125)2 + 0.2 (0.30 0.125)2 = 0.019375

b) i) The risk less interest rate, could be viewed as a form of asset where investor could lend or borrow to get 5% return for certain. For example, deposit in bank would certainly give investor a 5% return. In this portfolio, there are x% of risk less asset and (1-x)% of stock A. The price of the risk, which is the slope of the Risk-return trade off line: Hence, the equation of the line is: Expected Return = (27/26) Risk + 0.05 or r = (27/26) + 0.05

0.11750.05 0.065 27 26

Expected Return, r

= 0.05

Risk,

Standard deviation is a measure of risk of the portfolio. To find the risk at 7% return, substitute r = 7% on the above equation: So, =

26 27

0.07 = ( ) + 0.05

27 26

(0.07 0.05)

= 0.01926 = 1.926%. There is almost 2% of risk associated with a 7% return of this portfolio.

0.15 = ( ) + 0.05 =

27 26 26 (0.15 27

0.05)

However, it is not feasible to get r = 15% as the maximum expected return is 11.75%.The investor could expect to get as high as 11.75% of return if he invest 100% on stock A (if x = 0). He could get beyond 11.75% of return if he decides to make a borrowing.

ii) In this portfolio, there are x% of risk less asset and (1-x)% of stock B. The price of the risk, which is the slope of the Risk-return trade off line: Hence, the equation of the line is: Expected Return = (125/232) Risk + 0.05 or r = 0.538793 + 0.05 Expected Return

0.1250.05 0.1392 125 232

= 0.05

Risk,

To find the risk at 7% return, substitute r = 7% on the above equation: So, = 0.07 = (

= 0.03712 = 3.712%. Theres 3.712% risk associated with a return of 7% for this

portfolio.

125 ) + 0.05 232 232 = (0.15 0.05) 125

However, it is not feasible to get r = 15% for this portfolio as well. The maximum expected return is 12.5%. The investor could expect to get this return if he invest 100% on stock B and nothing on the less risk asset (if x = 0). The investor could get more than 12.5% of return if he decides to make a borrowing. iii) The decision to invest will depends on the expected return and the standard deviation (risk). We can compare the risk that yields the same return for both portfolios (i) and (ii). At 7% expected return, portfolio (i) has a lower risk of 1.926% than portfolio (ii) of 3.712%. So, I would choose portfolio (i) with a lower variance which implies a lower divergence of outcome from 7%. This portfolio comprises of: Since = 0, 7% = (1-x) + x .

x = 0.7037. So, my portfolio to get 7% expected return consists of 70.37% of risk less asset

My optimal portfolio would be determined by my preferences over return and risk. This can be illustrated in the indifference curve. The optimal choice is a point where the indifference curve tangential to the risk returns trade off line or when MRS =

QUESTION 5

An efficient portfolio is one that lies on the efficient frontier. This portfolio includes the lowest level of risk possible for a given level of expected return. An efficient portfolio also provides the best returns achievable for a given level of risk. An optimal portfolio is one in which investors try to minimize risk while determined to achieve the highest rate of return possible. Also, the composition of the optimal portfolio is to maximize utility. This is where the budget set is tangent to the indifference curve. This is the optimal point. At the optimal choice of risk and return, the slope of the indifference curve has to be equal to the slope of the budget constraint i.e MRS = (rm rf) / m.. The slope of budget constrained is called the price of risk, as it measures how risk and return can be traded off in making portfolio choices. In equilibrium it must be that the MRS between the risk and return must be equal to the price of risk.

The optimal and efficient portfolios consist of 2 stocks can be illustrated in the mean variance trade off diagram below

Indifference Curve Expected Return

A

Efficient Frontier

Variance is the measure of diversity between expected return and the outcome and this is represented by standard deviation as shown above. All the red dotted point shows portfolios that have better expected return than the portfolios contained within the line for the same level of risk (or standard deviation). Portfolio B is not efficient as it carries the same risk as portfolio A that have higher expected return. Moving from B to A can be done by properly adjusting the composition of assets in the portfolio. There are many efficient portfolios in the diagram, but the optimal one is portfolio A. This is the point where indifference curve tangential to the risk-return trade off line.

QUESTION 6 Probability 0.5 0.5 Stock A: Return -10 50 Probability 0.5 0.5 Stock B: Return -10 50

Variance (A2) = ( )2 = 0.5 (20-(-10))2 + 0.5 (20-50)2 = 0.5 (900) + 0.5 (900) = 450 + 450 = 900 Hence, Standard Deviation, A = 900 A = 30 For Stock B, Expected Return = = 0.5 (-20) + 0.5 (60) = (-10) + 30 = 20 Variance (B2) = ( )2 = 0.5 (-20-20)2 + 0.5 (60-20)2 = 0.5 x 1600 + 0.5 x 1600 = 800 + 800 = 1600 Hence, Standard Deviation, B = 1600 B = 40

b) This portfolio consists 50% of Stock A and 50% of Stock B. The probability distribution of the outcome is computed on excel as below: Possible outcome Stock A -10 -10 50 50 Stock B -20 60 -20 60

Probability, pi

1 2 1 2 1 2 1 2

x =

1 1 1

1 1

1 2

1 4 1

1 2

Return, ri * (-10) + (-20) = -15 (-10) + 2 (60) = 25 (50) + 2 (-20) =15 (50) + 2 (60) =55

1 1 1 1 2

1 2

1 2

* Return is calculated on basis that this portfolio consists of 50% of each stock.

1 2

So, the probability of obtaining return of (-15), (25), (15) and (55) are the same. The return follows a uniform distribution. Assuming the distribution as a continuous function instead of discrete, it can be shown in the diagram below: Probability, p

0.25

-15 Expected Return = = -3.75 + 6.25 + 3.75 + 13.75 = 20 The variance and standard deviation: Variance = (0.5)2 x A2 + (0.5)2 x B2 + 2 (0.5)(0.5) AB. Since correlation between the 2 stocks is 0, AB = 0, AB = = 0 = 0 Variance = (0.5)2 x 16 + (0.5)2 x 9 = 0.25 x 16 + 0.25 x 9 = 4 + 2.25 = 6.25%

55

Return, r

As we can see the variance and standard deviation is less in a diversified portfolio, reflecting a lower risk level. c) This portfolio consists 75% of Stock A and 25% of Stock B. Possible outcome Stock A -10 -10 50 50 Stock B -20 60 -20 60 Probability, p

1 2 1 2 1 2 1 2

x = x =

1 1 1 2

1 2

1 4 1 4 1 1

3 4

Return, r (-10) + (-20) = -15 (-10) + (60) = 25 (50) + 4 (-20) =15 (50) + 4 (60) =55

1 1 1 4 1 4

x2=4 x2=4

3 4

3 4

3 4

10

Expected Return = = 20 Variance = (0.75)2 x A2 + (0.25)2 x B2 (assuming the covariance between stock A and stock B is zero) 2 2 = 0.75 x 9 + 0.25 x 16 = 0.5625 x 9 + 0.0625 x 16 = 5.0625 + 1 = 6.0625% As we can see the variance and standard deviation is less in a diversified portfolio, reflecting a lower risk level.

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