P5-3 Risk preferences Sharon Smith, the financial manager for Barnett Corporation, wishes to evaluate three prospective investments: X, Y, and Z. Currently, the firm earns 12% on its investments, which have a risk index of 6%. The expected return and expected risk of the investments are aş follows: Iavestment Expected return Expected risk index 14% 7% Y 12 z 10 a. If Sharon were risk-indifferent, which investments would she select? Explain why. b. If she were risk-averse, which investments would she select? Why? c. If she were risk-seeking, which investments would she select? Why? d. Given the traditional risk preference behavior exhibited by financial managers, which investment would be preferred? Why?
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- "A financial investor has $31,000 to invest. The choices have been narrowed down to the following two options.-OPTION 1:Invest in a foreign bond that will mature in one year. This will entail an immediate brokerage fee of $100. For simplicity, assume that the bond will provide interest of $2,470, $2,130, or $1,527 over the one-year period and that the probabilities of these occurrences are assessed to be 0.29, 0.43, and 0.28, respectively.-OPTION 2:Invest in a $31,000 certificate with a savings-and-loan association. Assume that this certificate has an effective annual rate of 5.6%.Which form of the investment should the investor choose in order to maximize her expected financial gains? Enter the expected net gain (total return - initial investment - fee) of the preferred option."Suppose XYZ Corporation's stock price rises or falls with equal probability by $25 each month, starting where it ended the previous month. What is the value of a three month at the-money European call option on XYZ's stock if the stock is priced at $100 when the option is purchased?$______5. Find the expected value assuming the risk factor is 30 % and the interest rate is 12% , if you will receive $20,000 one year from today.
- 6- Suppose Firm B is selling 1 -year insurance contracts for houses. Suppose Firm B's customers are divided into three categories with different probabilities of needing a payment. First category will ask for a payment of 500000 with probability 0.10, the second category will ask for a payment of 250000 with probability 0.15 and the third category will ask for a payment of 100000 with probability 0.2 a. Calculate Firm B's expected payment for the year. Suppose Firm B has 120 customers in the first category, 230 in the second category and 405 in the third category. b. Calculate individual premium if Firm B charges the same amount to all its customers. 1 c. Calculate individual premium if Firm B utilizes the risk groups and charges the same amount of premium within groups d. Which group/groups are more likely to buy the insurance with group pricing compared to the case with uniform pricing?Person A, Person B and Person C own stock in the same company. All of them are loss averse and have the same value function: v(x) = x/2 for gains and v(x) = 2x for losses. The stock's price is shown in the graph below Stock Price 100 90 80 95 80 90 70 70 60 60 50 50 40 30 20 10 0 October November December January Feburary March (a) (b) O Person A bought the stock in November and uses the purchase price as their reference point. If you ask them, how much would they say that they lost in terms of value when the price dropped from £95 to £70? Person B bought the stock in October and uses the peak price as their reference point. If you ask them, how much would they say that they lost in terms of value in January? In January, which month should Person B rather use as reference point in order to maximize their value? (d) [ Person C bought the stock in March. They expect to derive a value of at least +5 in April as compared to their reference point of the purchase price. What is the minimum…9) A risk-neutral individual with current wealth w has already decided investing all his wealth in a project that has two possible net wealth outcomes wn and we (with probabilities pr and pe, respectively) where wr > w > we > 0, PrPe E (0,1), and pr + Pe = 1. Before he invests, he realises that there is a source of information that tells the individual which outcome will be realised with truth, what is the value of this information for the individual? a) pe(@ – w;), b) (Pn – Pe)w, c) Phwn + PeWe – w, d) Pr(w – wn).
- The demand D (in billions of £) for a bond with coupon rate 5% and face value FV = 1000, andtwo years to maturity as a function of its price P is D = 4000 − 2P. The supply in (billions of£) as a function of the price of the bond is S = 2P + 400. b) Suppose that the yield to maturity of the bond is i = 0.05. What is the quantitydemanded/supplied at this interest rate? What happens to the demand/supply of the bond asthe interest rate increases? Explain why. c) What is the equilibrium interest rate? d) Suppose that the bond trades at premium. Is there excess demand or supply? Explain.e) There is a business cycle expansion, so both supply and demand shifts. After the shift, thenew demand curve is given by: D = 4000 + X − 2P, whereas the new supply curve is S =2P + 200. For which values of X will the interest increase/decrease? Which values of X arein line with empirical data?The demand D (in billions of £) for a bond with coupon rate 5% and face value FV = 1000, andtwo years to maturity as a function of its price P is D = 4000 − 2P. The supply in (billions of£) as a function of the price of the bond is S = 2P + 400. b) Suppose that the yield to maturity of the bond is i = 0.05. What is the quantitydemanded/supplied at this interest rate? What happens to the demand/supply of the bond asthe interest rate increases? Explain why. c) What is the equilibrium interest rate?8. Risk and return Suppose Caroline is choosing how to allocate her portfolio between two asset classes: risk-free government bonds and a risky group of diversified stocks. The following table shows the risk and return associated with different combinations of stocks and bonds. Combination A BUDW C E Fraction of Portfolio in Diversified Stocks (Percent) 0 25 50 75 100 Average Annual Return (Percent) 3.50 7.50 11.50 15.50 19.50 Standard Deviation of Portfolio Return (Risk) (Percent) 0 5 10 Sell some of her stocks and place the proceeds in a savings account O Sell some of her bonds and use the proceeds to purchase stocks Accept more risk Sell some of her stocks and use the proceeds to purchase bonds 15 20 As the risk of Caroline's portfolio increases, the average annual return on her portfolio Suppose Caroline currently allocates 25% of her portfolio to a diversified group of stocks and 75% of her portfolio to risk-free bonds; that is, she chooses combination B. She wants to increase the…
- TRUE FALSE UNCERTAIN A driver of a luxury SUV has a 4 in 1,000,000 chance of dying in a car accident over the course of a year, while a driver of an economy sedan has a 12 in 1,000,000 chance of dying in a car accident over the course of a year. A one-year lease of the luxury SUV costs $20,000 while a one-year lease of the economy sedan costs $4,000. Based on this information, consumers are willing to pay $16,000 for an 8 in 1,000,000 reduction in mortality risk, implying a $2,000,000,000 ($2 billion) VSL. (Take the first two sentences as given. You should address whether the third sentence ["Based on this information..."] is true, false, or uncertain.)2 Consider the two investments listed below with possible outcomes and probabilities: INVESTMENT (in $1000) SAFE RISKY INVESTMENT AMOUNTⓇ 40+ 40+ GOOD SCENARIO OUTCOME 45+ 80+ AVERAGE+ SCENARIO PROB OUTCOME 0.40* 0.40€ 42+ 45+ BAD+ SCENARIO PROB OUTCOME PROB 0.20 35+ 0.20 10+ 0.40€ 0.40+ b) a) Suppose I have utility function U(*) = (x)2. What is the expected utility from each investment? Which investment will I choose, if any? Show and explain your work and provide the intuition. c) What is the value of the risk premium for the SAFE investment? Show and explain your work and provide the intuition. d) What is the value of the risk premium for the RISKY investment? Show and explain your work and provide the intuition.< +Suppose Caroline is choosing how to allocate her portfolio between two asset classes: risk-free government bonds and a risky group of diversified stocks. The following table shows the risk and return associated with different combinations of stocks and bonds.CombinationFraction of Portfolio in Diversified StocksAverage Annual ReturnStandard Deviation of Portfolio Return (Risk)(Percent)(Percent)(Percent)A 0 1.50 0B 25 3.00 5C 50 4.50 10D 75 6.00 15E 100 7.50 20There is a relationship between the risk of Caroline's portfolio and its average annual return.Suppose Caroline currently allocates 75% of her portfolio to a diversified group of stocks and 25% of her portfolio to risk-free bonds; that is, she chooses combination D. She wants to reduce the level of risk associated with her portfolio from a standard deviation of 15 to a standard deviation of 5. In order to do so, she must do which of the following? Check all that apply. Sell some of her stocks and use the proceeds to purchase…