Suppose that you use a quadratic utility function, U = E(r)-1/2A ² to make your financial

decisions. The average historical return for small US stocks is 15.12% with a standard

deviation of 33.21%. Suppose that you also use this for your estimates of E(r) and .

Part 1. Suppose that in choosing a portfolio consisting of a risk-free asset (where rf = 3%)

and small US stocks, you invest 40% of your money in small US stocks (and the rest

in the risk-free asset). What does this imply about your risk aversion coecient, A?

Part 2. If your preferences are consistent (i.e. you use the same utility function, including the

same A as above), which would you prefer?

(a) an asset which has E(r) = 5% and = 0

(b) an asset with E(r) = 10% and = 20%

Assume that you are only investing in (a) or (b) and not mixing the two assets into a

portfolio.