QuestionSharon Smith evaluates investments X, Y, Z against a 12% return, 6% std. dev. Select investments for risk neutral, averse, and seeking.
Studdy Solution
STEP 1
Assumptions1. The expected return and standard deviation of the current investments are12% and6% respectively.
. The expected returns and standard deviations of the prospective investments X, Y, and Z are as given in the table.
3. Risk neutral means the decision maker is indifferent to risk and only cares about expected return.
4. Risk averse means the decision maker prefers less risk for a given level of expected return.
5. Risk seeking means the decision maker prefers more risk for a given level of expected return.
6. Traditional risk preference behavior exhibited by financial managers is assumed to be risk averse.
STEP 2
If Sharon were risk neutral, she would select the investment with the highest expected return, regardless of the risk (standard deviation).
STEP 3
From the table, we can see that investment X has the highest expected return of14%.
STEP 4
Therefore, if Sharon were risk neutral, she would select investment X.
STEP 5
If Sharon were risk averse, she would select the investment with the highest expected return for a given level of risk, or the lowest risk for a given level of expected return.
STEP 6
From the table, we can see that investment X has a higher expected return than the current investments, but also a higher risk.
STEP 7
Investment Y has the same expected return as the current investments, but a higher risk.
STEP 8
Investment Z has a lower expected return than the current investments, but also a higher risk.
STEP 9
Therefore, if Sharon were risk averse, she would stick with the current investments.
STEP 10
If Sharon were risk seeking, she would select the investment with the highest risk for a given level of expected return.
STEP 11
From the table, we can see that investment Z has the highest risk of9%.
STEP 12
Therefore, if Sharon were risk seeking, she would select investment Z.
STEP 13
Given the traditional risk preference behavior exhibited by financial managers, which is risk aversion, Sharon would prefer the investment with the highest expected return for a given level of risk, or the lowest risk for a given level of expected return.
STEP 14
From the table, we can see that investment X has a higher expected return than the current investments, but also a higher risk.
STEP 15
Investment Y has the same expected return as the current investments, but a higher risk.
STEP 16
Investment Z has a lower expected return than the current investments, but also a higher risk.
STEP 17
Therefore, given the traditional risk preference behavior exhibited by financial managers, Sharon would stick with the current investments.
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