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Portfolio problem

  • 09-01-2009 10:38am
    #1
    qwertykeyboards
    Closed Accounts Posts: 48 ✭


    hi havin trouble workin this stupid thing out. i know that risk premium = expected return - riskfree rate but does expected return always = risk premium + risk free? any help solving this wud be appreciated.

    Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will
    be either €100,000 or €200,000 with equal probabilities of 0.5. The alternative riskfree
    investment in T-bills pays 5% per year.

    If you require a risk premium of 8%. how much will you be willing to pay for the
    portfolio'? (8 marks)


Comments

  • #2
    hivizman
    Registered Users, Registered Users 2 Posts: 1,163 ✭✭✭hivizman


    qwertykeyboards wrote: »
    hi havin trouble workin this stupid thing out. i know that risk premium = expected return - riskfree rate but does expected return always = risk premium + risk free? any help solving this wud be appreciated.

    Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will
    be either €100,000 or €200,000 with equal probabilities of 0.5. The alternative riskfree
    investment in T-bills pays 5% per year.

    If you require a risk premium of 8%. how much will you be willing to pay for the
    portfolio'? (8 marks)
    The mechanical answer to this would be to determine the expected cash flow from the portfolio, which is €150,000, and discount this by the expected return of 5 + 8 = 13%.

    But strictly speaking, the "risk premium" in portfolio theory is the additional return above the risk-free rate expected on the market portfolio (it's the slope of the capital market line), and the value of an individual investment or portfolio depends on the covariance of the portfolio with the market portfolio (measured by beta).

    Some economists argue that you should measure a "risk-adjusted certainty equivalent" value for the portfolio (the amount of money that you would be indifferent to receiving with certainty in one year's time in comparison with the stated portfolio) reflecting individual risk aversion and discount this at the risk-free rate. For example, you may be indifferent between the given portfolio and a certain receipt of €140,000. So you would value the portfolio by discounting the risk-adjusted certainty equivalent €140,000 by 5%.


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