Question

a Discuss a standard Investment Opportunity Locus, and how the choices of i) a very risk averse investor, ii) an investor with ‘normal’ risk aversion, and iii) a risk seeking investor will differ. b) Explain how money fits in a portfolio decision (as a riskless asset). In answering, show how money (as a riskless asset) alters the IOL and show an equilibrium holding of money and bonds. [Show and discuss the slope of this IOL]. Choose part c or d c) Explain and show what happens if interest rate on the risky asset rises. d) Explain and show what happens if wealth rises.

Answer 1

For a very risk averse investor, a conservative investment policy is what is preferred. For a given level of investment, the returns are always expected to be safe. Hence, the investment would be made on that stock which gives steady return, but at the same time, it involves very minimal risk.

For an investor with 'normal' risk aversion, the investment is made on those assets which give moderately high returns. The risk appetite of this particular type of investor is higher than a risk averse investor. A moderate investment strategy is followed.

A risk-seeking investor is always game for higher returns, but at the same time, he is also ready to take on a higher risk appetite. He/she chooses an aggressive investment strategy where the returns expected out of a given level of investment is really high.

The IOL curve is shown as follows:

Given is the investment strategies of a risk averse investor and a risk-seeking investor. As the curve moves towards the right, the risk appetite increases and the returns expected increases. The investment return demanded at each point in the curve increases.