Question

Indicate what values (positive, negative, zero) the Arrow-Pratt risk aversion coefficient takes for decision-makers who are risk averse, risk lovers, and risk neutral.

Answer 1

Risk Aversion is the behavior of humans (especially consumers and investors), who, when exposed to uncertainty, attempt to lower that uncertainty. It is the hesitation of a person to agree to a situation with an unknown payoff rather than another situation with a more predictable payoff but possibly lower expected payoff. For example, a risk-averse investor might choose to put their money into a bank account with a low but guaranteed interest rate, rather than into a stock that may have high expected returns, but also involves a chance of losing value.

Risk Averse means investor who prefers lower returns with known risks rather than higher returns with unknown risks. In other words, among various investments giving the same return with different level of risks, this investor always prefers the alternative with least interest. Such investors like to invest in government bonds, debentures and index funds.
Risk Lover means a person who is willing to take more risks while investing in order to earn higher returns. When it comes to taking risk for earning returns, different people have different attitudes. Some are risk lovers, some risk averse and some are neutral towards risk. Generally investments giving lower returns come with lower risks as well. On the other hand, investments giving higher returns involve higher risks.
Risk neutral is a term that is used to describe investors who are insensitive to risk. The investor effectively ignores the risk completely when making an investment decision. If you present a risk neutral investor with two possible investments that carry different levels of risk, he or she considers just the expected return from each investment their risks are irrelevant to him or her. Risk neutral is different from risk averse – which describes a person who chooses certainty and dislikes risk. The term is not the same as risk seeking either – which describes an investor who likes risk; if you like something you are not indifferent. The risk neutral investor is simply not interest in risk at all, risk does not enter his or her cognitive radar – he or she is indifferent – regardless of whether it is high or low risk.