Question

1. A situation exists in which there are the following five investment possibilities.

                        investment                                   expected return                                   risk

                                    A 6.50% 1.90%

                                    B                                               10.11% 11.50%

                                    C   7.54%   8.42%

                                    D                                                9.42%                                                12.65%

                                    E                                                7.00%                                                 1.60%

What can we say about the choice of a risk-averse, risk-loving, and risk-neutral individual? Explain.

Answer 1

A risk-averse investor will always choose E because it offers a good enough return with the lowest risk. Since A and E have very low risk, when we compare them we see that it doesn't make sense to choose A because compared to E, it is offering a lower return for a higher risk.

A risk-loving investor will choose the highest return available irrespective of the risk. Hence, he/she would take investment B. (Comparing B and D, B is better in terms of return as well as risk).

A risk-neutral investor will choose the option which has the highest return per unit of risk. Hence, the values of return per unit risk will be:

A = 6.5/1.9 = 3.421

B = 10.11/11.5= 0.879

C= 7.54/8.42 = 0.895

D = 9.42/12.65 = 0.7446

E = 7/1.6 = 4.375

Hence, E is the option a risk-neutral investor would choose.