Question

(a) Distinguish between risk Aversion, risk Neutrality and risk Loving. You are required to corroborate your response with examples or graphs.

(b) Distinguish between Certainty Equivalent and Risk Premium. You are required to corroborate your response with examples or graphs.

Answer 1

Risk Aversion, Risk Neutrality, and risk Loving:

Risk Averse person would immediately find himself leaning towards guaranteed payment. He will accept the payment without concerning about the amount. Some money is better than no money.

A risk-neutral person is indifferent to risks. This person makes the decision mathematically.

Risk lover is a complete opposite of a risk-averse person or a typical investor mentality. He will take increased risks if he sees the potential of an increased return.

For example - someone who is risk-averse might choose only $20 of guaranteed payment while a risk-neutral person might accept guaranteed payment only is it is $40 and otherwise choose not to have any if it's less than $40.

Certainty Equivalent and Risk Premium:

The certainty equivalent is a guaranteed return that someone would accept now, rather than taking a chance on a higher, uncertain, return in the future. Investments pay a risk premium to investors to compensate them for a possibility that they may not get their money back and higher the risk higher the premium an investor expects.