Question

Investor attitudes toward risk

Erik is an investor with $5,000 available for investment. He has the following three investment possibilities from which to choose:

Option	Scenarios
1	Keep the $5,000 in cash for one year.
2	Invest in a friend’s business with a 50% chance of getting $10,000 after one year and a 50% chance of getting nothing.
3	Invest in a relative’s business with a 30% chance of getting $15,000 after one year, 20% chance of getting $2,500 after one year, 50% chance of getting nothing.

Suppose Erik cares about the risk involved in Options 2 and 3, and decides to select Option 1 because it has no risk. Which of the following statements would be true about Erik?

He is risk-averse.

He is risk-neutral.

He is risk-loving.

None of these descriptions is accurate.

Suppose the market risk premium is currently 6%. If investors were to become more risk-averse, the market risk premium might increase to 8%. What effect would you expect this to have on the prices of most financial assets?

Prices would increase.

Prices would decrease.

Prices would be unaffected.

Answer 1

Eric is risk-averse

Risk averse is a person who doesn't take risk at all. Risk lover is someone who invests in risky investments and risk neutral lies in between.

Since, Eric doesn't take risk at all, he is risk averse

The prices would decrease

With investors becoming risk averse, market risk premium would increase leading to a rise in the expected return and hence, the prices of financial assets would decrease .