Fred, a financial manager, evaluates 3 prospectiveinvestments, A B C. The firm c

Question

Fred, a financial manager, evaluates 3 prospectiveinvestments, A B C. The firm currently earns 12% on itsinvestments, which have a risk index of 6%. The expected return andexpected risk of the investments are as follows: Investment Expected Return Expected Risk Index A    14%                               7% B      12                                   8    C      10                                  9 If Fred were risk - averse, which investment would he select?Explain why. Fred, a financial manager, evaluates 3 prospectiveinvestments, A B C. The firm currently earns 12% on itsinvestments, which have a risk index of 6%. The expected return andexpected risk of the investments are as follows: Investment Expected Return Expected Risk Index A    14%                               7% B      12                                   8    C      10                                  9 If Fred were risk - averse, which investment would he select?Explain why.

Explanation / Answer

Fred would select A. Currently for the firm, for every 1% in the risk index, it earns a12/6 = 2% return. For investment A, for every 1% in the risk index, it also earns a14/7 = 2% return. The other investments have higher risk as well as lower expectedreturn, and thus are inferior to a risk-neutral investor.

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