Assume an investor with the following utility function: U = E(r) − 0.60(s²). To maximize her expected utility, which one of the following investment alternatives would she choose? A) A portfolio that pays 10% with a 60% probability or 5% with 40% probability. B) A portfolio that pays 10% with 40% probability or 5% with a 60% probability. C) A portfolio that pays 12% with 60% probability or 5% with 40% probability. D) A portfolio that pays 12% with 40% probability or 5% with 60% probability.

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Quizplus · Accepted Answer

The investor's utility function places a premium on the expected return (E(r)) while penalizing variance or risk (as indicated by the complex term involving S and P, which are not directly relevant to the calculation of expected return). To maximize utility, the investor would prefer the option with the highest expected return without considering the variance explicitly given in the question. Calculating the expected return for each option: A) 0.6*10% + 0.4*5% = 8%, B) 0.4*10% + 0.6*5% = 7%, C) 0.6*12% + 0.4*5% = 8.2%, D) 0.4*12% + 0.6*5% = 7.8%. Option C offers the highest expected return of 8.2%.

Assume an Investor with the Following Utility Function: U =