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CFA Level I · CFA Level I Exam · The Return and Risk of a Financial Portfolio

Using U = E(R) − 0.5 × A × σ², an investor with A = 2 considers a risk-free asset yielding 3%. A risky portfolio has a standard deviation of 10%. The expected return that would make the investor indifferent between the two is closest to:

The required expected return is about 4%. The risk penalty is 0.5 × 2 × 0.10² = 1%, and adding it to the 3% risk-free utility gives the return at which the investor is indifferent.

  1. A3%
  2. B4%Correct
  3. C13%

Explanation

Indifference requires U of risky = 0.03. Penalty = 0.5 × 2 × 0.01 = 0.01. Required E(R) = 0.03 + 0.01 = 4%. Using 3% ignores the penalty.

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