Question

To model investor behavior, economist refers to three fundamental concept- utility functions, probability distribution, and portfolio possibilities set:

a. Name maim three properties of utility functions that describe investor's objectives?

b. What is the purpose of probability distribution?

c. What is the effect of investment restriction on the portfolio possibilities set?

Answer 1

Ans a.The main properties of utility functions that describe investor's objectives are:

1.) Firstly, there is availability of various investments in which the investor could invest , thus, the investor will always invest in that investment where he /she will get the highest return for the risk he/she is bearing.

2.)The second property is that how much risk the investor is ready to take .Under this comes :

Risk averse investor:This kind of investor will go for risks which are known inspite of the lower returns from investments rather than for unknown risks even if the return might be high .Basically investor is at peace of mind in this case.

Risk neutral investor:In this case the investor is indifferent regarding risks but definately expects that he/she must receive the return which commensurate the degree of risk undertaken.

Therefore this depends on the preference of the investor and various other factors influencing the behaviour of the investor while making the investments.

3.) The third one depends on the fact that the preferences and choices regarding the investment to be made by the investor also depends on his/her wealth.

Ans b. The probability distribution is a concept of statistics which depicts the chances of every outcome.Thus in finance terms from investors point of view , this fundamental concept is useful as through it chances of risk with their respective returns can be analysed and investment decision can be taken rationally.

Ans c. Portfolio investments means the invests not only in one security but in more than one security. Portfolio possibilities set are the risk return possibilities and the investor will want to have lower risk with the same returns, also known as optimal portfolio set.The investors also have this assumption that higher the risk , higher is the return and the investment restriction will arise when highest risk is undertaken and comparatively lower return is achieved.