Reference no: EM132798212

Consider the following four stocks:

Stock Expected Return (E[r]) Standard Deviation

A 0.12 0.30

B 0.15 0.50

C 0.21 0.16

D 0.25 0.21

1) According to the mean-variance dominance principle, which stock a rational and risk-averse investor will choose from stocks A, B and C? How does this choice compare with stock D?

2) An investor's risk preferences are characterized by the following utility function:

U=E(r)-0.5Aσ2

Assume that for this investor: A=4. Based on this utility function, should the investor select stock C or stock D?

3) Besides the four risky assets, now the investor can also invest in a newly issued T-bill withannual rate of return at 5%. With risk-aversion level at A=4, the investor is considering to hold a portfolio of the stock (the stock that you picked from part 2) and the risk-free assets, instead of just holding the stock alone. Is this a wise decision for the investor? Why or why not. If so, how will the investor allocate between the stock and risk-free assets?