Question

You are considering two assets with the following characteristics:

E(R1) = 0,15 E(σ1) = 0,10 w1 = 0,5

E(R2) = 0,20 E(σ2) = 0,20 w2 = 0,5

1. Answer below
   1. Define correlation coefficient
   2. Define risk averse, risk neutral, gambler behaviors
   3. Define the characteristic of an investor who tries to invest with a portfolio

Answer 1

1) The correlation coefficient is a statistical measure that is used to define the strength of the movement of the relationship between two securities returns. The value of correlation lies between -1 to +1. Negative correlation shows that values are negatively correlated and positive correlation shows that values are positively correlated.

2) Risk averse is a type of human behavior in which an individual avoids taking risk and chooses an outcome where the certainty is more. An example of risk averse behavior can be when investors avoids equities and chooses Fixed deposit investment. Risk neutral behavior is when the investor ignores risk while taking on decision when people have excess capital, this type of behavior can be expected. Gamblers behavior is when people take investment decision where the probability of gain and lose is equal and both can result in either significant gains or significant losses.

3) When an investor tries to create a portfolio of securities then this behavior is more consistent with risk averse where the investor tries to create a portfolio of securities in such a way that the overall risk of the portfolio reduces. When an investor will create a portfolio, he will be adding securities where the correlation between the returns is negative so that the risk of the portfolio reduces.