Assume an investor with the following utility function: U = E(r) - 3/2(s 2 ).
-To maximize her expected utility,which one of the following investment alternatives would she choose?
A)A portfolio that pays 10 percent with a 60 percent probability or 5 percent with 40 percent probability.
B)A portfolio that pays 10 percent with 40 percent probability or 5 percent with a 60 percent probability.
C)A portfolio that pays 12 percent with 60 percent probability or 5 percent with 40 percent probability.
D)A portfolio that pays 12 percent with 40 percent probability or 5 percent with 60 percent probability.
E)none of the above.

Question

Quizplus · Accepted Answer

The investor's utility function includes an expected return component (E(r)) and a risk aversion component (-3/2(s²)). The risk aversion component implies that the investor is risk averse and wants to minimize variance. Option A has an expected return of 0.6(10%) + 0.4(5%) = 8%, which is lower than option C's expected return of 0.6(12%) + 0.4(5%) = 9.2%. Option A also has a higher variance than option C, since the probabilities are spread out more evenly. Option B has the same expected return as option A, but with a different probability distribution. It also has a higher variance than option C. Option D has a higher expected return than option C, but also has a higher variance. Therefore, option C is the best choice as it maximizes expected return while minimizing variance, which aligns with the investor's risk aversion.

Assume an Investor with the Following Utility Function: U =