(b) Rate of return = 5% (save rate) + 10% (risk premium) = 15%
(a) Projected cash flow: (50,000*0.6) + (150,000*0.4) = $90,000.
.... Est. Value = 90,000 / 0.15 = $600,000
(c) Est. Value = 90,000 / 0.20 = $450,000
(d) The higher the risk premium, the lower the value of the portfolio.
Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $50,000 with probability 0.6 or $150,000 with probability 0.4. The alternative riskless investment in T-bill pays 5%.
(a) If you require a risk premium of 10%, how much will you be willing to pay for the portfolio?
(b) Suppose the portfolio can be purchased for the amount you found in (a). What will be the expected rate of return on the portfolio?
(c) Now suppose you require a risk premium of 15%. What is the price you will be willing to pay now?
(d) Comparing your answers to (a) and (c), what do you conclude about the relationship between the required risk premium on a portfolio and the price at which the portfolio will sell?
