medium · Quantitative Finance numerical
In the Merton optimal portfolio problem, the optimal fraction of wealth to invest in the risky asset is w^* = (μ - r)/(γ σ^2).
What happens if the investor's coefficient of relative risk aversion γ increases?
- The investor allocates less to the risky asset.
- The investor switches entirely to the risky asset to hedge against inflation.
- The allocation remains unchanged as long as μ - r is positive.
- The investor allocates more to the risky asset to earn more return.
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