Q) Ed Smith has risk-return indifference curves that are steeper than those of Meg Jones. Which of the following statements best describes the risk preferences of the investors and risk-return characteristics of their optimal portfolios, assuming they have the same market expectations.
A. Smith is more risk averse than Jones, and his optimal portfolio has less risk than Jones’ optimal portfolio.
B. Smith is less risk averse than Jones, and his optimal portfolio has a lower expected return than Jones’ optimal portfolio.
C. Smith is more risk averse than Jones, and his optimal portfolio has a greater expected return than Jones’ portfolio.
Answer: A
I would have though it could be A or C? As an investor who is relatively more risk averse requires a relatively greater increase in ecpected return to compensate for a given increase in risk.
Because jones has a flatter risk-return indeifference curve, she is willing to accept significantly less return than Smith for a given increase in the risk level.
So if Jones only requires 1% extra return for 1% additional risk, then Smith might require 3% extra return for 1% additional risk.
Therefore Smith is more risk averse, because he requires more return relative to Jones to take on additional risk.
I encourage you to draw a picture of an efficient frontier, draw a steep line tangent to it, and draw a not-so-steep line tangent to it. The steep line should be tangent at a point with low return and low standard deviation of returns, while the not-so-steep line should be tangent at a point with a higher return and a higher standard deviation of returns.
Thank you! What would we do without you S2000magician!
Makes perfect sense, the risk averse investor would choose an optimal portfolio with more invested in the risk free asset, so would earn lower returns but have less risk!
You’d figure it out; there are lots of other helpful people here.
But my life would be considerably less interesting.
I was thinking about it as if the efficient frontier had only risky assets, but you can include the risk-free asset and arrive at the same conclusion. Good job.