Question

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either $115,000 or $270,000 with equal probabilities of .5. The alternative risk-free investment in T-bills pays 4% per year. a. If you require a risk premium of 4%, how much will you be willing to pay for the portfolio?

Answer 1

$178,241

Step-by-step explanation:

The computation of the value of the portfolio is shown below:

= (Cash flow × equal probabilities + Cash flow × equal probabilities) ÷ ( 1 + risk-free investment + risk premium)

= ($115,000 × 0.5 + $270,000 × 0.5) ÷ ( 1 + (4% + 4%))

= ($57,500 + $135,000) ÷ (1.08)

= ($192,500) ÷ (1.08)

= $178,241

We simply multiply the cash flows with the equal probabilities and then divided it with the risk-free investment and risk premium