Question

[7 Marks] Q 2(a) Explain the concept of risk aversion and explain the ways in which risk aversion may be estimated. Q 2(b) [18 Marks] Explain the concept of indifference curves and, from this, explain the following graphic, which shows a set of alternative indifference curves drawn over the capital allocation line (CAL). Note that $r_f$ is the risk-free rate, P is the risky portfolio and C is the optimal complete portfolio. Make sure to explain these concepts in your answer. $E(r) = 15$ $E(r) = 1028$ $r_f = 0.07$ $U = 0.94$ $U = 0.8653$ $U = 0.78$ $U = 0.7$ CAL Tangency point $\left(\bar{r}, \bar{\sigma}\right)$, $\text{tangent to CAL max utility}$ $U = E(r) - \frac{1}{2} \times A \times \sigma^2$ $y^* = \frac{E(r_p) - r_f}{A \sigma_p^2} = \frac{0.15 - 0.07}{4 \times 0.22^2}$ $P$ $\sigma_p = 0.902$ $\sigma_p = 0.22$ Figure 6.8 Finding the optimal complete portfolio by using indifference curves Source: Bodie, Z., Kane, A., Marcus, A.J. (2011). Investments and Portfolio Management, Gobal Edition. [End of Question 2]

          [7 Marks]
Q 2(a)
Explain the concept of risk aversion and explain the ways in which risk aversion may
be estimated.
Q 2(b)
[18 Marks]
Explain the concept of indifference curves and, from this, explain the following
graphic, which shows a set of alternative indifference curves drawn over the capital
allocation line (CAL). Note that $r_f$ is the risk-free rate, P is the risky portfolio and C is
the optimal complete portfolio. Make sure to explain these concepts in your answer.
$E(r) = 15$
$E(r) = 1028$
$r_f = 0.07$
$U = 0.94$
$U = 0.8653$
$U = 0.78$
$U = 0.7$
CAL
Tangency point $\left(\bar{r}, \bar{\sigma}\right)$,
$\text{tangent to CAL max utility}$ 
$U = E(r) - \frac{1}{2} \times A \times \sigma^2$
$y^* = \frac{E(r_p) - r_f}{A \sigma_p^2} = \frac{0.15 - 0.07}{4 \times 0.22^2}$
$P$
$\sigma_p = 0.902$
$\sigma_p = 0.22$
Figure 6.8 Finding the optimal complete portfolio by using indifference curves
Source: Bodie, Z., Kane, A., Marcus, A.J. (2011). Investments and Portfolio Management, Gobal Edition.
[End of Question 2]

[7 Marks]
Q 2(a)
Explain the concept of risk aversion and explain the ways in which risk aversion may
be estimated.
Q 2(b)
[18 Marks]
Explain the concept of indifference curves and, from this, explain the following
graphic, which shows a set of alternative indifference curves drawn over the capital
allocation line (CAL). Note that rf is the risk-free rate, P is the risky portfolio and C is
the optimal complete portfolio. Make sure to explain these concepts in your answer.
E(r) = 15
E(r) = 1028
rf = 0.07
U = 0.94
U = 0.8653
U = 0.78
U = 0.7
CAL
Tangency point (r̅, σ̅),
tangent to CAL max utility
U = E(r) - (1)/(2)× A ×σ^2
y^* = (E(rp) - rf)/(A ^2) = (0.15 - 0.07)/(4 × 0.22^2)
P
= 0.902
= 0.22
Figure 6.8 Finding the optimal complete portfolio by using indifference curves
Source: Bodie, Z., Kane, A., Marcus, A.J. (2011). Investments and Portfolio Management, Gobal Edition.
[End of Question 2]

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