1. a. Suppose you forecast that the standard deviation of the market return will be 20% in the coming year. If the measure of risk aversion in Equation 5.17 is A = 4, what would be a reasonable guess for the expected market risk premium?
b. What value of A is consistent with a risk premium of 9%? In other words, what should be the value of A for a risk premium of 9%?
c. What will happen to the risk premium if investors become more risk tolerant?
2. You manage an equity fund with an expected risk premium of 10% and a standard deviation of 14%. The rate on Treasury bills is 6%. Your client chooses to invest $60,000 of her portfolio in your equity fund and $40,000 in a T-bill money market fund.
What is the expected return (10 points) and standard deviation (10 points) of return on your client's portfolio?
Hints:
Calculate the expected return for your equity fund. Then, you can calculate the expected return on your client’s portfolio – weighted average of equity fund returns and T-bill rate.
Standard deviation of overall portfolio is the standard deviation of the risky asset (equity fund here) times the fraction of the portfolio invested in the risky asset.