Question

Investor attitudes toward risk

Erik is an investor with $5,000 available for investment. He has the following three investment possibilities from which to choose:

Option	Scenarios
1	Keep the $5,000 in cash for one year.
2	Invest in a friend’s business with a 50% chance of getting $10,000 after one year and a 50% chance of getting nothing.
3	Invest in a relative’s business with a 30% chance of getting $15,000 after one year, 20% chance of getting $2,500 after one year, 50% chance of getting nothing.

Suppose Erik cares about the risk involved in Options 2 and 3, and decides to select Option 1 because it has no risk. Which of the following statements would be true about Erik?

He is risk-averse.

He is risk-neutral.

He is risk-loving.

None of these descriptions is accurate.

Suppose the market risk premium is currently 6%. If investors were to become more risk-averse, the market risk premium might increase to 8%. What effect would you expect this to have on the prices of most financial assets?

Prices would increase.

Prices would decrease.

Prices would be unaffected.

Answer 1

1) Erik is risk-averse as he is not investing his money because he doesn't want to take the risk of losing it.

2) if market risk premium increases let's analyze the cost of equity using the CAPM model

cost of equity = risk-free rate + Beta*(Market risk premium)

since market risk premium increases hence it will increase the cost of equity since the cost of equity increases hence for discounting all cash flows we will have a higher WACC due to the higher cost of equity and hence price of all the assets would decrease.