Question

You are a risk-averse investor. Investment A has E(r) =12% and standard deviation = 18%.

Investment B has standard deviation = 24% and has end of year cash flows of either $84,000

or $144,000 with equal probability. At what price for Investment B would you be indifferent

between A and B? Hint: think about individual security selection statistic...not portfolio.

Answer 1

Investment A's return per unit of risk is 0.12/0.18 = 0.67. For the investor to be indifferent about A and B, B's return per unit of risk should also be 0.67. Therefore, the expected return on investment B is 0.24*0.67 = 16%.

Now, the expected dollar amount to be received after 1 year in investment B is 0.5*84,000 + 0.5*144,000 = $114,000. Therefore, given the expected return and the dollar amount expected to receive after 1 year, the current price is:

P(1+0.16) = 114,000

P = $98,275.86