Question

1. Consider two individuals. Both earn the same amount and choose to save the same amount. However, the first agent is more risk averse than the second.

i) Do you expect the saving portfolios to be different for the two agents? Which of the two is more likely to hold stocks?

Now, assume that the second individual is actually much wealthier than the first.

ii) Do you expect the two agents to rely on the same type of financial intermediaries? Which of the two is more likely to interact with a hedge fund/mutual fund?

Continue to assume that the second individual is much wealthier. But, now, imagine that the two individuals decide to deposit all their savings in a commercial bank.

iii) Which of the two individuals is exposed to higher risk? What would happen if the bank were to become insolvent?

Answer 1

1. (i) The risk bearing capacity of the investors effect their investment decisions. A risk lover investor will be more likely to invest in risky portfolios like stocks and a risk averse investor is more likely to invest in risk free securities like government bonds.

The savings portfolio of the two individuals earning the same amount and choosing to save the same amount will be different. First agent will invest in risk free or less risky portfolio including government bonds etc. Second agent will invest in stocks and commodities. Second agent is more likely to buy stocks.

(ii) Financial intermediaries like Insurance company, Mutual funds, financial advisors and credit union facilitates investors to invest in right securities with expertise.

Second individual being wealthy will choose an intermediary like credit union. First individual being risk averse and less wealthy is likely to choose mutual funds.

First individual will choose hedge fund or mutual fund because a mutual fund takes small amount of money from investors and invest it all together and the fund managers are knowledgeable experts. First individual is less wealthy and risk averse is more likely to invest in such funds.

(III) If both investors invest all their money in the commercial bank second individual is exposed to higher risk due to higher investment made by him. If the bank becomes insolvent he shall lose all his savings which are more than the first investor