A finance company would like to engage in asset management within the firm. The firm measured its coefficient of absolute risk aversion A for all of its clients—the coefficients of absolute risk aversion range from -5 to 10. The client has to choose an investment to invest in, and the investments’ risks and returns are given in the table below.
Investment Expected Return, E(r) Standard Deviation,
A 0.12 0.30
B 0.15 0.50
C 0.21 0.16
D 0.25 0.21
a). All individuals have the utility function: U = E(r) – 1/2A*(Standard Deviation Squared). For all values in the absolute risk aversion range, identify which investment best suits an individual. Describe the results as ranges of the risk aversion parameter and present them in graphical form.
b). Based on the results in the analysis in a, what recommendations would you make to the CEO about the make-up of the company’s investments?