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4: Conclusions
George Pennacchi
University of Illinois
Introduction
N.B.: all lotteries have the same payo set fx1 ; :::; xn g, so we
focus on the (dierent) probability sets P and P .
P + (1 )P P + (1 )P
P + (1 )P P y + (1 )P
5) Dominance
Let P 1 be the compound lottery 1 P z + (1 y
1 )P and P
2 be the
compound lottery 2 P z + (1 y
2 )P . If P
z P y , then P 1 P 2 if
and only if 1 > 2 .
George Pennacchi University of Illinois
Expected utility and risk aversion 10/ 58
1.1: Preferences 1.2: Risk Premia 1.3: Portfolio Choice 1.4: Conclusions
Allais Paradox
Allais Paradox
P2 P 5 + (1 ) P1
0:11f1=11; 0; 10=11g + 0:89f0; 1; 0g
f:01; :89; :1g
Allais Paradox
Note also that P 1 is trivially the compound lottery
P 1 + (1 ) P 1 . Hence, if P 1 P 2 , the independence
axiom implies P 1 P 5 .
Now also dene P 6 = f1; 0; 0g, and note that P 3 equals the
following compound lottery:
P3 P 5 + (1 ) P6
0:11f1=11; 0; 10=11g + 0:89f1; 0; 0g
f:9; 0; :1g
while P4 is equivalent to the compound lottery
P4 P 1 + (1 ) P6
0:11f0; 1; 0g + 0:89f1; 0; 0g
f:89; 0:11; 0g
George Pennacchi University of Illinois
Expected utility and risk aversion 14/ 58
1.1: Preferences 1.2: Risk Premia 1.3: Portfolio Choice 1.4: Conclusions
Allais Paradox
ei Ui en + (1 Ui )e1 (2)
P p1 e1 + ::: + pn en
X 1
1 i 1 1 1
= p 1 p = 1 p
i =0
2 2 1 p12 2
1
= p = 1:707
2 2
A certain payment of 1:7072 = 2:914 ducats has the same
expected utility as playing the St. Petersburg game.
George Pennacchi University of Illinois
Expected utility and risk aversion 21/ 58
1.1: Preferences 1.2: Risk Premia 1.3: Portfolio Choice 1.4: Conclusions
Risk Aversion
E [e
"] = p"1 + (1 p)"2 = 0 (9)
E [U(~
x )] < U(E [~
x ]) (13)
Therefore, substituting x~ = W + e
" with E [e
"] = 0, we have
E [U(W + e
")] < U (E [W + e
"]) = U(W ) (14)
Risk Premium
For small e
" we can take a Taylor approximation of equation
(15) around e" = 0 and = 0.
Expanding the left-hand side about = 0 gives
E [U(W + e
")] = E U(W ) + e "2 U 00 (W )
"U 0 (W ) + 12 e (17)
2
= U(W ) + 0 + 1
2 U 00 (W )
where 2 "2 is the lotterys variance.
E e
U 00 (W ) and U 0 (W )
Consider the following negative exponential utility function:
bW
U(W ) = e ;b > 0 (19)
R(W ) ) U(W )
1 W
U(W ) = + (30)
1
W
s:t: 6= 1, > 0, 1 + > 0, and = 1 if = 1.
1
W
Thus, R(W ) = 1 + . Since R(W ) must be > 0, it
1
W
implies > 0 when > 1. Rr (W ) = W 1 + .
HARA utility nests constant absolute risk aversion ( = 1,
= 1), constant relative risk aversion ( < 1, = 0), and
quadratic ( = 2) utility functions.
George Pennacchi University of Illinois
Expected utility and risk aversion 37/ 58
1.1: Preferences 1.2: Risk Premia 1.3: Portfolio Choice 1.4: Conclusions
Risk Premium v2
Prob(win) p = 12 (1 + )
Prob(lose) = 1 p = 12 (1 )
~
W = (W0 A)(1 + rf ) + A(1 + ~r ) (37)
= W0 (1 + rf ) + A(~r rf )
~
is satised because U 00 W 0 from concavity.
dv (W 0 ) @f (A(W 0 );W 0 )
The total derivative simplies to dW 0 = @W 0 :
Thus, the derivative of the maximized value of the objective
function with respect to a parameter is just the partial
derivative with respect to that parameter.
Second, consider how the optimal value of the control
variable, A (W0 ), changes when the parameter W0 changes.
We can derive this relationship by taking the total derivative
of the (39) @f (A (W0 ) ; W0 ) =@A = 0 with respect to W0 :
@(@f (A(W 0 );W 0 )=@A) 2f (A(W 0 );W 0 ) dA(W 0 ) @ 2 f (A(W 0 );W 0 )
@W 0 = 0 =@ @A 2 dW 0 + @A@W 0
dA
Implications for dW0 with DARA
dA
Implications for dW0 with DARA
A
Adding 1 A to the right-hand side of (49) gives
(dA=dW0 )W0 A
=1+ (50)
A
Substituting dA=dW0 from equation (42), we have
h i h i
~ )(~r rf ) + AE U 00 (W
W0 (1 + rf )E U 00 (W ~ )(~r rf )2
= 1+ h i
~ )(~r rf )2
AE U 00 (W
(51)
Collecting terms in ~ )(~r
U 00 (W rf ), this can be rewritten as
h i
~ )(~r
E U 00 (W
rf )fW0 (1 + rf ) + A(~r rf )g
= 1+ h i (52)
AE U 00 (W ~ )(~r rf )2
h i
~ )(~r rf )W
E U 00 (W ~
= 1+ h i (53)
AE U 00 (W~ )(~r rf )2
h i h i
E W~ U 00 (W
~ )(~r rf ) > ~ )(~r
E U 0 (W rf ) W0 (1+rf )R(W0 (1+rf ))
(58)
The rst term on the right-hand side is just the FOC, so
inequality (58) reduces to
h i
E W ~ U 00 (W
~ )(~r rf ) > 0 (59)
Conclusions
We have shown: