Question

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $70,000 or $195,000, with equal probabilities of 0.5. The alternative riskless investment in T-bills pays 4%. a. If you require a risk premium of 8%, how much will you be willing to pay for the portfolio?

Answer 1

Answer: $118,304

Explanation:

Given the following:

End of year cashflow of portfolio is either :

$70000 or $195,000

Probability of either equals = 0.5

With a riskless investment in T-bills of 4% and a risk premium of 8%, then the expected rate of return = 12%

Therefore ;

Amount of portfolio × (1 + expected rate of return) = expected cashflow.

Expected cash flow = probability × end of year cashflow

Expected cashflow = (0.5 × 70000) + (0.5 × 195000)

= 35000 + 97500 = $132500

Therefore ;

Amount of portfolio × (1 + 0.12) = 132500

Amount of portfolio × 1.12 = 132500

Amount of portfolio = 132500/1.12

Amount of portfolio = $118,303. 57

=118,304