Indifference Curves

Question 1

What are Indifference Curves?

Answer 1

• Each client needs their portfolio to match their level of risk and this can be done by incoporating their risk tolerance into the portfolio selection process
• Utility = expected return - risk of portfolio
• Where risk of portfolio = expected STDEV / Risk tolerence score
• This gives investment suitability and client utility per portfolio
• The higher the level of utility, the more optimal the portfolio.
• Lower utility scores are caused by risk aversion
• The formula acts as a risk penalty and the smaller the risk tolerances the the higher the risk aversion and the greater the risk penalty.
• The utility from a portfolio increases as the expected rate of return increases and it decreases when the expected variance increases.

Question 2

What is risk aversion scores

Answer 2

• Risk aversion is the inverse of risk tolerance
• RA = 1/RT
• E.g Sophie has a risk tolerance of 8 so her risk aversion is = 1/8

Question 3

What are the merits and drawbacks of utility functions?

Answer 3

• Merits
  
  • Combines investment risk with risk tolerance to arrive at a more holistic approach to the return derived from a certain portfolio and its return.
  • Easy to calculate and explain.
  • Allows you to allocate investment portfolios to clients that may not have that differing objectives.
• Drawbacks
  
  • Dones not include risk need or risk capacity.
  • The risk tolerance score is somewhat subjective, hard to define and suspect to behaviroural finance biases.

Question 4

What is Certainty Equivalent?

Answer 4

• It is the rate that if earned with certainty would provide a utility score equivalent to a portfolio adjusted for risk aversion.
• Therefore, we only accept a portfolio it its certainty equivalent returns exceed that of the risk-free rate.
• If certainty equivalent return of the risk free portfolio is large or equal to certainty equivalent return of the risk portfolio the investor will reject the risk portfolio.
• This concept suggests that as households hold a lot of risk free assets that lots of households are highly risk averse.

Question 5

Define risk appetite, risk capacity and risk need?

Answer 5

• Risk appetite
  
  • The is the risk that people want to take.
  • To find this out you need a risk questionaire to find objectives, experience, knowledge, what concerns they might have and how they might feel in market corrections.
  • This is a very psychological viewpoint.
• Risk capacity
  
  • This is the amount of risk risk that a person can take.
  • This is a financial viewpoint based on ability to withstand loss.
  • Is independent of risk appetite.
  • Low for people that have no savings, low earners or high number of dependents.
  • Age, wealth, health and the amount of remaining human capital should be included.
• Risk need
  
  • This is the amount of risk that people need to take in order to achieve their investment objective.
  • This is an investment objective point of view.
  • Need to know the investment objective and how important it is to reach this objective.
  • How aggressive and what is the time scale.
• Additional comments
  
  • There is often tension between the three;
    
    • Some people believe that young people have the capacity to take investment risk. Yet younger people often reach more negative to volatility and loss - their risk appetite is low. They may be saving for a deposit or to purchase a car.