An investment company has complied information about a specific investment portfolio (e.g. Fund A) that delivers on an annual basis (date-0 to date-1) either a 8% net return with probability 98.5%, or alternatively the fund defaults with probability 1.5% leading to loss of the investment. Thus the investment company is expected to generate a net return equal to r on an initial investment value. Two risk-averse investors (1) and (2) indicate that, given the risk profile described, they are willing to pay the following self-declared amounts:

 

where CEQ(1) and CEQ(2) are the certainty equivalents for investors (1) and (2), respectively, and£471.56 and £316.75 are observed prices for risk asked by risk-averse investors (1) and (2). (1) The investment company lacks knowledge of the investors' preferences and intends to determine their risk-aversion attitudes based on a general power characterisation given by U := (X1−γ)/(1 − γ). Given the observed prices for risk, find each investor's risk-aversion parameter γ (consider that the investors weigh payoffs equally over time i.e. no time discounting).

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CEQ (¹) CEQ (2) = = (1+r) x £10, 000-£471.56 Expected value at date-1 (1+r) x £10, 000 £316.75 Expected value at date-1. CEQ (¹) CEQ (2) = = (1+r) x £10, 000-£471.56 Expected value at date-1 (1+r) x £10, 000 £316.75 Expected value at date-1.

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he question describes an investment scenario where an investment company offers a portfolio Fund A w... View the full answer