ACCA Financial Management (F9) Certification Practice Exam

What is the general impact of higher risk on certainty equivalent value?

1. It increases the certainty equivalent value

2. It does not affect certainty equivalent value

3. It decreases the certainty equivalent value

4. It may cause fluctuations in certainty equivalent value

The correct answer is: It decreases the certainty equivalent value

The impact of higher risk on certainty equivalent value is that it decreases the certainty equivalent value. The certainty equivalent is a risk-adjusted measure of value that reflects an investor's preference for certain outcomes over uncertain ones. When an investment carries higher risk, investors typically require a higher return to compensate for that risk. As a result, the amount that they would consider equivalent to a certain (risk-free) outcome is reduced. For example, if investors face the risk of potential losses, they will value guaranteed returns less than uncertain, potentially higher returns. Consequently, for a given risky investment, a higher risk reduces the value that investors assign to the certain outcome they would require, thus leading to a lower certainty equivalent value. Essentially, with increased risk, investors are likely to perceive a greater gap between the certain amount they would accept and the uncertain prospects presented, resulting in a decrease in the certainty equivalent value.