Suppose an investor is offered the investment opportunities described in the tab

Question

Suppose an investor is offered the investment opportunities described in the table below. Each investment cost $1,000 today and provides a payoff, also described below, one year from now. Which of the following would a risk-neutral investor prefer? The investor will be indifferent toward these options. The investor will choose option 1. The investor will choose option 2. The investor will choose option 3. Which kind of stock is most affected by changes in risk aversion? (In other words, which stocks have the biggest change in their required returns?) Low-beta stocks All stocks are affected the same, regardless of beta. High-beta stocks Medium-beta stocks

Explanation / Answer

Payoff of option 1,

= $ 1,100 * 1 = $ 1,100

Payoff of option 2,

= 0.5 * $ 1,000 + 0.5 * $ 1,200 = $1,100

Payoff of option 3,

=0.5 * $ 200 + 0.5 * $ 2,000 = $ 1,100

As the payoff is same for all the three options therefore a risk neutral investor will be indifferent towards these options.

The stocks is most affected by changes in risk aversion are high beta stocks because movement is faster in high beta stocks.

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