1a. Imagine you are talking to a friend who knows nothing about risk. How would

Question

1a.     Imagine you are talking to a friend who knows nothing about risk. How would you explain the difference between an investor who is risk neutral and one who is risk averse? In your explanation, use at least one example to illustrate your point.

1b.     Imagine you're talking to the same friend from discussion 1. They have questions about forward and future contracts as well. Compare and contrast forward and future contracts (explain their similarities and their differences) in your own words. Use examples if they are helpful. Be sure to identify the advantages of each.

Explanation / Answer

Answer

1-(A) Difference between an investor who is risk neutral and one who is risk averse:

Risk-neutral: Risk neutral is indifference to risk. The risk-neutral investor would be in the middle of the continuum represented by risk-seeking investors at one end, and risk-averse investors at the other extreme. So what is a risk-neutral investor? As you might have guessed, a risk-neutral investor will make his or her decision mathematically. Say the payment were less than $50. If you are risk-neutral, you will choose the coin toss. If the payment is more than $50, you will choose the guaranteed payment. What if the guaranteed payment is exactly $50? According to economic definitions, a truly risk-neutral person would choose the guaranteed payment.

Risk-averse: If you are a risk-averse investor, you will find yourself immediately leaning toward the guaranteed payment. Depending on just how risk-averse you are, you may immediately accept it without concerning yourself with the amount. After all, some money sure beats no money. You do not perceive this as a “nothing to lose” scenario, because the guaranteed payment is technically yours by right should you accept it. You stand to lose that account receivable if you choose Option 2. But you might consider accepting the coin toss depending on the amount of the guaranteed payment of Option 1. Someone who accepts a guaranteed payment of, say, $20, is more risk-averse than someone who will only accept the guaranteed payment if it is $45, and might otherwise choose the coin toss and risk losing.

1-(B)Compare and contrast forward and future contracts :

Futures contracts are similar to forward contracts as they both are obligations to purchase
or sell currency at a set rate on a specific settlement date in the future. However, they differ from
forward contracts because futures have standard contract specifications, while the details of forward
contracts are individually negotiated with the bank.
Futures contracts specify a standard number of units of currency per contract, and offer greater
liquidity than forward contracts. Because currency futures contracts are standardized into small
amounts, they can be valuable for the speculator or small firm (a commercial bank's forward
contracts are more common for larger amounts). However, the standardized format of futures forces
limited maturities and amounts.

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