Lecture 2 - Risk Aversion and Utility Theory Flashcards
Describe the characteristics of risk seeking/loving investors.
- Prefer higher risk to lower risk for a given level of expected return.
- Will accept less expected return because of the extra utility from the risk.
Describe the characteristics of risk neutral investors.
- Care only about expected return and not about risk.
- Higher return investments are more desirable even if they come with higher risk.
Describe the characteristics of risk averse investors.
- Prefer lower risk to higher risk for a given expected return.
- Will only accept riskier investments if they are compensated in the form of greater expected return.
What is a fair game?
A risky investment with a risk premium of zero.
How would risk loving investors react to a fair game?
They would choose a fair game.
How would risk averse investors react to a fair game?
They would reject a fair game.
What is risk tolerance?
The amount of risk an investor is willing to tolerant to achieve an investment goal.
How is risk aversion related to risk tolerance?
Negatively related. If an investor is more risk averse then they are less risk tolerant.
Most investors are…
Risk averse.
A portfolio is more attractive when its…
Expected return is higher and its risk is lower.
What does utility theory allow us to do?
Quantify the rankings of investment choices using risk and return.
In general terms, what is utility?
Utility is a measure of relative satisfaction from consumption of various goods and services.
In the case of investments, an investor derives satisfaction from…
Different portfolios.
In a world with no uncertainty, investors could maximise their utility by…
Simply selecting the assets that yield the highest returns.
In a real world, investors must maximise their expected utility from…
Risky investments.
