decisions. The average historical return for small US stocks is 15.12% with a st

Question

decisions. The average historical return for small US stocks is 15.12% with a standard

Part 1. Suppose that in choosing a portfolio consisting of a risk-free asset (where rf = 3%)

and small US stocks, you invest 40% of your money in small US stocks (and the rest

in the risk-free asset). What does this imply about your risk aversion coecient, A?

Part 2. If your preferences are consistent (i.e. you use the same utility function, including the

same A as above), which would you prefer?

Assume that you are only investing in (a) or (b) and not mixing the two assets into a

portfolio.

Explanation / Answer

Part 1

We have the following formula for risk aversion coefficient, A:

Hence, risk aversion coefficient is 2.75

Part 2

We will choose asset A as it has higher return than risk free rate and risk is same as risk free rate that is 0%. Therefore, there is no addition to risk but addition to return.

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