1) E(r) = 0.40(12%) + 0.60(2%) = 4.8% + 1.2% = 6%
The expected return on the risky portfolio is the same as the return on the risk free asset. Thus, the investor is not being rewarded for his/her risk - e.g. there is no risk premium. You wouldn't invest in an asset that MIGHT return 6% when your alternative is to invest in an asset that WILL return you 6%.
A riskfree security pays a 6% rate of return. A risk averse investor invest ______
in a risky portfolio that pays 12% with a probability of 40% or 2% with a probability of
60% because ______
A. might; she is rewarded a risk premium
B. would not; she is not rewarded any risk premium
C. would not; the risk premium is small
D. cannot be determined
