Question: You are thinking about investing in a risky portfolio. In one year, you expect the portfolio to be worth either $120,000 or $160,000, with equal probability, and you expect to receive $4,000 in dividends. The interest rate on one-year T-bills is 3%.
a. If you require a risk premium of 7%, how much would you be willing to pay for the portfolio?
b. Suppose the portfolio can be purchased for the amount found in part (a). What is the expected return on the portfolio?
c. Now suppose you require a risk premium of only 4%. What is the new price that you would be willing to pay? In general, if investors' required risk premium changes over time, what effect will this have on stock prices?