Indifference Curve

Risk Averse
• Risk-averse firms are interested in the lowest risk securities and the weight of the
investments is more important than the accumulated returns. Firms choose
securities that guarantee lower returns with the least amount of risks.
• Risk aversion is assumed under uncertainty.
• Risk-averse firms are interested in investments that have performed steadily for a
considerable period of time. Investments provide low but guaranteed returns
over a specified period and are considered safe and secure.
• Risk averse preferences is willing to take an amount of money smaller than the
expected value.
• In a 50/50 lottery between 1 million and 0 value, a risk averse firm would be indifferent at an
amount strictly more than 500,000.
• Risk aversion means that a firm values each additional amount at less than the
previous. These preferences explain why firms buy insurance.
Risk Neutral
• Mentality in which a firm is indifferent to risk when deciding to invest. This
mentality derived not from calculation or rational deduction but is an
emotional preference.
• If the firm focuses solely on potential benefits irrespective of the risk, they
are considered to be a neutral risk.
• Risk-neutral measures have extensive application in derivatives pricing
because the price at which investors would be expected to display a risk-
neutral attitude should be a price of balance between buyers and sellers.
• Risk neutral preferences maximize expected value.
• Consider a lottery that gives 1 million 50% of the time and 0 value 50% of the time. A
risk neutral firm would be indifferent between the lottery and receiving 500,000 with
certainty.
Risk Seeking
• Risk seeking choices are consistently observed in economic analysis of
decision under uncertainty.
• Risk-seeking choices are observed in two classes of decision problems.
• Prefer a small probability of winning a large prize over the expected value of that
prospect.
• Risk seeking is prevalent when firms must choose between a sure loss and a
substantial probability of a large loss.
• Risk acceptant preferences requires an amount of money greater than the
expected value.
• In the 50/50 lottery between 1 million and 0 value, a risk seeker would be indifferent
at an amount strictly lesser than 500,000.
• Risk acceptance means that a firm values each unit of a currency more
than the previous. Risk seeker could exhibit behaviors similar to a
compulsive gambler.
Utility Function
• Utility function gives the relationship between utility and return (or wealth)
when the returns are risk-free.
• Risk-Neutral Utility Functions: Firms are indifferent to risk. They only
analyze return when making investment decisions.
• Risk Seeking Utility Functions: For any given return, firms prefer more risk.
• Risk-Averse Utility Functions: For any given return, firms prefer less risk.
• Consider the utility function xa, where x is the amount of money a firm
receives. a = 1 represents risk neutral preferences; a > 1 represents risk
acceptant preferences; a < 1 represents risk averse preferences.
• Expected utility theory enables modeling risk preferences. However, those
preferences should be directly built into the payoffs in a game matrix.
 Return (%) Probability E ( r) Std ( r)
Utility Function 10% 0.5 0.05 0.02
50% 0.5 0.25 0.02
0.3 0.2
• Risk Neutral Firm
• E ( r) = (0.5 x 100) + (0.5 x 500) = 300
• Expected utility of risky investment is equal to utility associated with risk-free
utility (300) [Assume risk free rate as 30%)
Marginal
• (Ui) = 10 x ri : Constant Utility Return Utility Utility
0 0
10 100 100
20 200 100
30 300 100
40 400 100
50 500 100
Risk Neutral Utility Function
Risk Neutral Firm
600
500
400
Utility

300
200
100
0
0 10 20 30 40 50 60
Return (%)
(Ui) = 10 x ri : Constant Utility
 Return (%) Probability E ( r) Std ( r)
Utility Function 10% 0.5 0.05 0.02
50% 0.5 0.25 0.02
0.3 0.2
• Risk Seeking Firm
• E ( r) = (0.5 x 60) + (0.5 x 500) = 280
• Expected utility of risky investment is higher than that of risk-free rate utility
(240)
• (Ui) = 5 ri + 0.1 ri^2 Increasing Utility Marginal
Return (%) Utility Utility
0 0
10 60 60
20 140 80
30 240 100
40 360 120
50 500 140
Risk Seeking Utility Function
Risk Seeking Firm
600
500
400
Utility

300
200
100
0
-100 0 10 20 30 40 50 60
Return (%)
(Ui) = 5 ri + 0.1 ri^2 Increasing Utility
 Return (%) Probability E ( r) Std ( r)
Utility Function 10% 0.5 0.05 0.02
50% 0.5 0.25 0.02
0.3 0.2
• Risk Averse Firm
• E ( r) = (0.5 x 180) + (0.5 x 500) = 340
• Expected utility of risky investment is lower than that of risk-free rate utility
(420)
Marginal
• (Ui) = 20 x ri – 0.2 ri^2 : Decreasing Utility Return (%) Utility Utility
0 0
10 180 180
20 320 140
30 420 100
40 480 60
50 500 20
Risk Averse Utility Function
Risk Averse Firm
600
500
400
Utility

300
200
100
0
0 10 20 30 40 50 60
Return (%)
(Ui) = 20 x ri – 0.2 ri^2 : Decreasing Utility
Risk Attitude
Risk Return Curve
100
Expected Return (%)

80
60
40
20
0
5 10 15 20 25 30
Perceived Risk % (Standard Deviation)
Market Return Risk Averse Risk Seeking
Certainty Equivalent
• Risk Seeking Firm
• (Ui) = 5 ri + 0.1 ri^2 Increasing Utility
• E ( r) = (0.5 x 60) + (0.5 x 500) = 280
−5+ 25−4×0.1×−280
• Certainty Equivalent = = 33.5%
2×0.1

• Firm would be indifferent between receiving 33.5% risk-free and

investing in a risky asset that has E(r) = 30% and σ(r) = 20%
Certainty Equivalent
• Risk Averse Firm
• (Ui) = 20 x ri – 0.2 ri^2 Decreasing Utility
• E ( r) = (0.5 x 180) + (0.5 x 500) = 340
−20+ 400−4×−0.2×−340
• Certainty Equivalent = = 21.7%
2×−0.2
• Firm would be indifferent between receiving 21.7% risk-free and
investing in a risky asset that has E(r) = 30% and σ(r) = 20%
Indifference Curve
• Indifference curve generated for any given level of utility as a
quadratic function:
• 𝐸 𝑢 = 𝑎0 + 𝑎1 𝐸 𝑟 +𝑎2 𝐸 𝑟 2 + 𝑎3 𝜎 2 𝑟
• Solving for σ(r ):
𝐸 𝑢 𝑎0 𝑎1 𝐸 𝑟
•𝜎 𝑟 = − − −𝐸 𝑟 2
𝑎2 𝑎2 𝑎2
Indifference Curves
Indifference Curve
60
Expected Return (%)

40

20

0
0 10 20 30 40 50 60 70
Perceived Risk % (Standard Deviation)
Risk Neutral Risk Seeking Risk Averse
Illustration
• (Ui) = 20 x ri – 0.2 ri^2 Marginal
Return (%) Utility Utility
• Risk Computation:
0 0
• a0=0; a1=20;a2=-0.2 10 180 180
𝐸 𝑢 𝑎0 𝑎1 𝐸 𝑟 20 320 140
•𝜎 𝑟 = − − −𝐸 𝑟 2
𝑎2 𝑎2 𝑎2 30 420 100
180 𝑎0 20𝑥20 40 480 60
• Return: 20 :: − − − 20 2
−0.2 𝑎2 −0.2 50 500 20

180 𝑎0 20𝑥30
• Return: 30 :: − − − 30 2 ……………….
−0.2 𝑎2 −0.2
Portfolio Risk Preference
Market Application
• A firm’s indifference curves identify the maximum utility given a
market risk return setting represented by the efficient set of
investment possibilities.
• Maximizing utility is by finding the point of tangency between an
indifference curve and the efficient set.
• With a quadratic utility function, as wealth level increases, willingness
to take on risk decreases (both absolute risk aversion and relative risk
aversion increase with wealth levels). However, since investors are
willing to take on risk, other mathematical functions (logarithmic)
may be more appropriate.
Risk Tolerance
• Value that a firm is willing to handle for an investment.
• Risk tolerance indicates the value of potential losses a firm is willing
to risk in order to achieve the expected investment return.
• High risk tolerance implies the firm is less likely to be risk averse in
investment decision-making. A lower level of risk tolerance may lead
to conservative decision-making and lower investment returns.
• Scale of risk tolerance
• Low Tolerance: Forego investment gains to safeguard capital.
• Moderate: Balance risk and return.
• High Tolerance: Maximize investment returns by accepting volatility in return.
Risk Tolerance Perception
Perceived Risk (%) Expected Return (%) Expected Return (%) Expected Return (%)
10 8 12 20
15 10 20 30
25 13 40 60
40 16 65 90
65 24 85 140
85 35 100 180
Slope 0.34 1.17 2.13
Risk tolerance (1-slope)% 79 45 28
Risk Degrees(ATAN(slope)/90*100
Percentage 20.79 55.08 72.00
Risk Seeking Moderate Risk Averse

ATAN function: Arc tangent (inverse tangent)- Angle in radians

Perceived Risk of Investors
Risk Tolerance
200
Expected Return (%)

150
100
50
0
10 15 25 40 65 85
Perceived Risk (%)
Risk Seeking Moderate Risk Averse