Practice Quiz

FRM Financial Risk Manager Practice Test

Category - Risk

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Britney has the following utility function:U(w)=w2. Given that the second derivative is positive, what is her attitude to risk?
  1. Risk-averse.
  2. Risk-averse at low levels of wealth and risk neutral as wealth increases.
  3. Risk-loving.
  4. Risk-averse for low levels of wealth and risk loving at higher levels of wealth.
Explanation
Britney is a risk loving person, since the second derivative of her utility function is positive. Utility function in finance is a function that specifies the satisfaction of an investor for her wealth levels. It represents both his welfare and his preferences.

Key Takeaway: If there is a lottery and Britney prefers the expected value of the lottery to the lottery itself, she is risk averse. If she is indifferent between the expected value of the lottery and the lottery itself, then she is risk neutral. And if she prefers the lottery itself to the expected value of the lottery, then she is a risk lover.
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