Question

A risky portfolio pays a 15% rate of return with probability 60% in a good state or a 5% return with probability 40% in a bad state, and a T-bill pays 5%. The risk premium on the risky investment is

Answer 1

The risk premium on the risky investment is 8%

Step-by-step explanation:

The first portfolio pays 15% rate of return with probability 60% in a good

The second portfolio 5% return with probability 40% in a bad state

The risk port-folio expected return = 60% * 15% + 40% * 5%

Expected return = 0.6 * 15% + 0.4* 5%

Expected return = 0.09 + 0.02

Expected return = 0.11

Expected return = 11%

Risk premium on the risky investment = Expected return - Risk free rate

= 11% - 5%

= 8%

The risk premium on the risky investment is 8%