Question

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $130,000 or $250,000 with equal probabilities of 0.5. The alternative risk-free investment in T-bills pays 4% per year. a. If you require a risk premium of 5%, how much will you be willing to pay for the portfolio? (Round your answer to the nearest whole dollar amount.) b. Suppose that the portfolio can be purchased for the amount you found in (a). What will be the expected rate of return on the portfolio? (Round your answer to the nearest whole number.) c. Now suppose that you require a risk premium of 12%. What price are you willing to pay? (Round your answer to the nearest whole dollar amount.)

Answer 1

a) $174,312

b) 9%

c) $163,793

Step-by-step explanation:

the expected cash flow of the risky portfolio = ($130,000 x 0.5) + ($250,000 x 0.5) = $190,000

a) the price of this portfolio assuming a 4% risk free rate + 5% risk premium = expected cash flow / (1 + risk free rate + risk premium) = $190,000 / 1.09 = $174,311.93 ≈ $174,312

b) since you discounted the value of the expected cash flow by 9%, the expected return will also be 9% (= risk free rate + risk premium)

c) the price of this portfolio assuming a 4% risk free rate + 12% risk premium = expected cash flow / (1 + risk free rate + risk premium) = $190,000 / 1.16 = $163,793.10 ≈ $163,793