Question

Identify each of the following as being consistent with risk-averse, risk-neutral, or risk-seeking behaviour in investmentproject selection. Explain your answers.

1. Larger risk premiums for riskier projects

2. Preference for smaller, as opposed to larger, coefficients of variation

3. Valuing certain sums and expected risky sums of equal dollar amounts equally

4. Having an increasing marginal utility of money

5. Ignoring the risk levels of investment alternatives

Answer 1

The following behaviour can be identified:

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If an investor seeks a larger risk premiums for riskier projects, then this is classified as risk-averse behaviour. This is because the risk premium is large - the investor has quantified the value of the risk and requires to be compensated for the risk.

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If the investor has preference for a smaller, as opposed to a larger, coefficient of variation, it shows risk-averse behaviour. The CV is a measure for risk, and a preference for a lower CV clearly shows that the investor would not like to take risks.

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If an investor values certain sums and expected risky sums of equal dollar amounts equally, this shows risk-neutral behaviour. The investor assigns the same utility to risk and no-risk. No separate premium has been assigned to risk.

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If an investor has an increasing marginal utility of money, this shows risk-seeking behaviour. The investor gains more utility from more money, and doesn't consider the risks involved in gaining more money.

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If an investor ignores the risk levels of investment alternatives, this is risk-neutral behaviour. The investor has not assigned any premium to risk, and has ignored risk altogether. The investor doesn't seek risk, but has not quantified risk either.