10% 20.0% 10 .005 4 400 2

15 25.5 15 .005 4 650 2

20 30.0 20 .005 4 900 2

25 33.9 25 .005 4 1,150 2

Note that each portfolio offers identical utility, because the high-return portfolios also have high risk.

CONCEPT C H E C K ☞

QUESTION 4

a. How will the indifference curve of a less risk-averse investor compare to the indifference curve drawn in Figure 6.2?

b. Draw both indifference curves passing through point P.

6.2 PORTFOLIO RISK

Asset Risk versus Portfolio Risk

Investor portfolios are composed of diverse types of assets. In addition to direct invest- ment in financial markets, investors have stakes in pension funds, life insurance policies with savings components, homes, and not least, the earning power of their skills (human capital).

Investors must take account of the interplay between asset returns when evaluating the risk of a portfolio. At a most basic level, for example, an insurance contract serves to re- duce risk by providing a large payoff when another part of the portfolio is faring poorly. A fire insurance policy pays off when another asset in the portfolio-a house or factory, for example-suffers a big loss in value. The offsetting pattern of returns on these two assets (the house and the insurance policy) stabilizes the risk of the overall portfolio. Investing in an asset with a payoff pattern that offsets exposure to a particular source of risk is called hedging.

Insurance contracts are obvious hedging vehicles. In many contexts financial markets offer similar, although perhaps less direct, hedging opportunities. For