How different sets of indifference curve result

Reference no: EM133366683

Case: There are three possible assets in which to invest. Treasury Bills yield a return of 3% with zero risk. Investing in a stock market index yields an expected gain of 14% with standard deviation (a mea- sure of risk) 5%. Finally, buying stock in a new venture fund yields an expected gain of 18% with a standard deviation of 15%. Assume that if an investor buys $1 of a stock market index and $1 of a new venture index, then the expected value is 16% (the average of 14 and 18) and the standard deviation is 10% (the average of 5 and 15). Sup- pose moreover the investor has standard preferences over expected return and risk (as measured by standard deviation).

(a) Represent the three assets on a xy plane, with return on the x axis and risk on the y axis. Draw the feasible set of combinations of risk and return.

(b) Explain how different preferences, indicated by different indifference curve mappings, reflect different degrees of risk aversion. (Hint: note that risk is a "bad", not a "good".)

(d) Show that a rational investor will choose at most two different types of investment.

(e) In practice, investment portfolios frequently include more than two types of investment. What features of the problem (not included in the previous set of assumptions) explain this pattern? (Hint: The podcast, How Investment Advisors Invest Their Money, partly answers this question.)

Reference no: EM133366683

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