Reference no: EM132857964

Question:

Investor A has a square root utility function (i.e., U(W) = logarithmic utility function (i.e., U (W ) = ln W ). Both investors have initial wealth W0 = $1, 000 and must decide how much how much to invest in a bond and how much to invest in a stock. The current (t = 0) prices of the bond and stock are B0 and S0 respectively.

Both investors expect to receive income from selling these securities at their t = 1 prices, which are B1 for the bond and S1 for the stock. Since the bond is riskless, its t = 1 price is known with certainty to be B1 = B0(1+r), where r is the riskless rate of interest. The price of the stock at t = 1 can be high or low; i.e., it will be S0(1+s) with probability .6 and it will be S0(1-s) with probability .4. Furthermore, assume that r = .02 and s = .12.

A. How much (in dollars and percentages) of Investor A's initial wealth should be invested in the stock and in the bond?

B. How much (in dollars and percentages) of Investor B's initial wealth should be invested in the stock and in the bond?