5. Investor attitudes toward risk Suppose an investor, Erik, is offered the inve

Question

5. Investor attitudes toward risk Suppose an investor, Erik, is offered the investment opportunities described in the table below. Each investment costs $1,000 today and provides a payoff, also described below, one year from now. Option Payoff One Year from Now 100% chance of receiving $1,100 50% chance of receiving $1,000; 50% chance of receiving $1,200 50% chance of receiving $200; 50% chance of receiving $2,000 3 If Erik is risk averse, which investment will he prefer? The investor will choose option 1. The investor will choose option 2. The investor will choose option 3. O The investor will be indifferent toward these options.

Explanation / Answer

Risk Averse:

These types of investors are unwilling to take risk. They should be offered with premium to motivate them to take risk

Return from Option 1 = 1100*100% = 1100

Return from Option 2 = 1000*50%+1200*50% = 1100

Return from Option 3 = 200 * 50% + 2000*50% = 1100

Investors who are risk averse will opt for option 1 because it gives the same expected return for no risk.

When market risk premium increases from 6% to 8% the prices would decrease

Example:

Case 1 assume Risk free rate = 4%

Market risk premium = 6%

And Beta = 1

And price be 1000

Therefor required return = Risk free rate + Beta * Market risk premium = 4+1*6 = 10%

Price = 1000/1+Required return = 1000/1.10= $909

Case 2 assume Risk free rate = 4%

Market risk premium = 8%

And Beta = 1

And price be 1000

Therefor required return = Risk free rate + Beta * Market risk premium = 4+1*8 = 12%

Price = 1000/1+Required return = 1000/1.12 = $893

So when market premium increase from 6% to 8% the price drops from $909 to $893

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