Question

On April 4th 2020, Business Line reported that due to the COVID-19 pandemic, the world is facing a recession, that economic output is shrinking and growth is sharply lowered. These scenarios are affecting corporate earnings as well as stock prices where prices were sent crashing and investors were left gasping for breath. In response to the COVID-19 pandemic, the Federal government of Malaysia has taken a preventive measure by imposing movement control order (MCO) since March 18th 2020.

Given 3 investors, Mak Cik Kiah who is a risk-averse investor; Mr Lee who is a risk-neutral investor; and Mr. Kane who is a risk-loving investor. Discuss on how the current investment scenario in Malaysia impact Mak cik Kiah’s, Mr. Lee’s and Mr. Kane’s investment. Please discuss using the following tools: draw the indifference curve for each investor (you may want to provide numerical example), explain the nature and characteristic of each curve and the reasons for its shape, assess the theoretical value of these curves in the portfolio building process.

Answer 1

IN this lockdown situation, Malaysia had announced a movement control order (MCO)to keep safe their population from COVID 19 at the same time the work should not be stopped. so it keeps engaging their people in the safest manner.

Different investors exhibit different levels of risk taking capabilities. For each investor the degree of risk aversion can be determined through the level of investment. For example of $100 for a definite return, on high risk $200 or nothing, when a investor is a risk averse chooses to go with $100 for sure, it means that the $100 is sure compare to high risk. For some investor $90 may be good enough for him to find more utility compared to going for a high risk. If the amount is decrease another 20then he may go for risk taking attitude.

1. Utility increases as expected returns increase

2. Utility decreases when variance or risk increases

3. Utility reduces as risk-aversion (A) increases

When the risk increases, the investor demands more return based on his utility function, so the level of utility same. This concept can be explained with the help of indifference curve. An indifference curve presents the risk-return requirements of an investor at a certain level of utility. The following graph shows three indifference curves for the same investor.

Note that each of the curves (IC1, IC2, and IC3) represents different levels of utility for the investor. However, on any one indifference curve, the utility is the same anywhere on the curve. For example, on indifference curve C1, the investor gets same level of utility (satisfaction) at both points P1 and P2. Similarly, the the other indifference curves represent their points as providing similar level of utility say P3 and P4. Now let’s compare points P4 on IC2 and P6 on IC3. On point P4, is comparatively more risky then P4. So, given a choice, he can increase is utility by moving to the indifference curve IC3.

In general, the utility of risk-averse investors increases as we move leftwards in the graph. Given a choice between IC1, IC2, and IC3, the investor would want to be on IC3 to maximize this utility.

The indifference curve will have different shape for different types of investors as shown in the following graph.