Question

In the field of financial management, it has been observed that there is a trade-off between the rate of return that one earns on investments and the amount of risk that one must bear to earn that return. Consider the rate of return to be a “good”. For each of the following scenarios, sketch three indifference curves for risk and return. Label your curves as IC1, IC2, and IC3, where U1 < U2 < U3.

1. Draw a set of indifference curves for a person who likes risk and is willing to give smaller and smaller amounts of risk for each additional unit of return.

2. Draw a set of indifference curves for a person who likes a little risk but dislikes a lot of it.

Answer 1

The risk-retun indifference curve shows different combination of the risk and return which gives him the same amount of utility.

Answer to the question no. 1:

In this case the investor is risk lover. The following figure (figure 1) shows the risk-return indifference curve of a risk lover:

Answer to the question no. 2:

In this case the investor is less risk lover (who takes less risk than the previous example). The following figure (figure 2) shows the risk-return indifference curve of a the person who takes less risk than the earlier investor in question no 1:

Note: Here, we can see that the person who loves to take less risk is having a indifference curve which is steeper than the person who takes more risk to gain additional unit of return.

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