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Q8I.

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Essentials Of Investments
Found in: Page 142
Essentials Of Investments

Essentials Of Investments

Book edition 9th
Author(s) Zvi Bodie, Alex Kane, Alan Marcus, Alan J. Marcus
Pages 748 pages
ISBN 9780078034695

Short Answer

a. Suppose you forecast that the standard deviation of the market return will be 20% in the coming year. If the measure of risk aversion in Equation 5.13is A 5 4, what would be a reasonable guess for the expected market risk premium? b. What value of A is consistent with a risk premium of 9%? c. What will happen to the risk premium if investors become more risk tolerant? (LO 5-4)

The correct answer is:

a.8%

b.4.5%

c. Decline in risk premium

See the step by step solution

Step by Step Solution

Step 1: Given information

A = 4

σP = 20%

E (rP) – rF = 9%

Step 2: Calculation of expected market risk premium

E (rP) – rF = ½A σP2 = ½ x 4 x (0.20)2 = 0.08 = 8.0%

Step 3: Calculation of value of A

E (rP) – rF = ½A σP2

0.09 = ½ A (0.20)2

A = 0.09/ (1/2 x 0.04) = 4.5

Step 4: Effect of risk tolerance on risk premium

The increased risk tolerance means decreased risk aversion. This would result in a decline in risk premiums.

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