TMC Lecture2

Risk and lotteries 1st order SD White noises 2nd order SD Aversion to downside risk Background risk
Lecture 2: Risk preferences and stochastic

dominance1
September 5, 2017
1
Those slides come from Pierre Chaigneau.
Preferences and utility functions

The expected utility criterion
I Future income of an agent: x. Random future income
denoted by x [x, x].
I A lottery is simply a probability distribution of x in the [x, x]
interval. For continuously distributed outcomes in this range,
a lottery Li is defined by a probability density function, fi , or
equivalently by a cumulative distribution function, Fi (with
Rk
Fi (k) = x fi (s)ds = Pr (x k) ).
I Economic agents have preferences over lotteries: they know
how to rank several possible probability distributions of future
income.
I We know that if individual preferences satisfy certain axioms,
then lotteries can be compared using the expected utility
criterion: an individual with wealth w prefers a lottery A to a
lottery B if and only if
E [u(w + xA )] > E [u(w + xB )]
The risk-return tradeoff

I Definition of the certainty equivalent CE :

E [u(w + x)] = u w + CE
I Definition of the risk premium :

E [u(w + x)] = u w + E [x]
I In the special case where E [x] = 0, we have CE = .
I For example, with CARA utility (u(w ) = exp{w }) and a
normally distributed variable, the certainty equivalent is linear
in the mean and the variance of the payoff.
I The risk-return tradeoff at the margin:
E [u(w + x)] = u(w ) + u 0 (w )E [x] + 0.5u 00 (w )E [x 2 ] + o(x 2 )
I A risk averse agent (u 00 (w ) < 0) is willing to bear a small risk
x only if E [x] > 0.
Why not simply use the mean and the variance of returns?
Only valid in special cases
I Lotteries cannot be compared on the basis of their respective

means and variances, unless
I The investor only cares about the first two moments of his
future wealth: either he is risk neutral or he has quadratic
utility.
I The probability distribution is fully parameterized by its mean
and its variance.
I In general, higher-order moments matter: skewness, kurtosis.
I Arrow-Pratt risk premium: proportional to the variance of the
risk. But it is an approximation, which only applies to small
risks.
I Fact: daily returns are approximately normal (but fat tails).
I Compounded i.i.d. returns are lognormally distributed.
An example borrowed from Brunnermeier
s=1 s=2 E [r ]
Investment 1 5% 20% 12.5% 7.5%
Investment 2 50% 60% 5.0% 55.0%
Investment 3 5% 60% 32.5% 27.5%
I Investment 1 mean-variance dominates investment 2.
I However, investment 3 does not mean-variance dominate
investment 1. . .
Another example borrowed from Brunnermeier
s = 1 (proba = 0.5) s = 2 (proba = 0.5)

Investment 4 3% 5%
Investment 5 3% 8%
I Sharpe ratio: commonly used measure to rank portfolios:
E [r ] rf
SR =
r
I For rf = 0, investment 4 has a higher Sharpe ratio than
investment 5 !
Stochastic dominance
I Given some properties of u, what can we say about the
ranking of different lotteries? Put differently, given some
characteristics of the agents preferences, do we know which
kind of distribution of future revenues he prefers?
I Make minimal assumptions about preferences: postulate only
risk aversion, say.
I Fundamental question: are there some conditions under which
a lottery A is preferred to a lottery B by ALL economic agents
of a certain type? This is the case if
E [u(xA )] > E [u(xB )]
for all u with certain characteristics (to be defined). Then we

say that A dominates B.
Stochastic dominance
When can we say that a lottery A is preferred to a lottery B?
I State-by-state dominance: the payoff of lottery A is higher

than the payoff of lottery B in every possible state A
dominates B.
I Several types of stochastic dominance:
I First order stochastic dominance: for all increasing utility
functions (u 0 > 0)
I Second order stochastic dominance: for all risk averse agents
(u 0 > 0 and u 00 < 0)
I Third order stochastic dominance: for all risk averse and
prudent agents (u 0 > 0, u 00 < 0, and u 000 > 0)
First order stochastic dominance

Applies to all increasing u, but only to a few lotteries
I FA first order stochastically dominates FB if and only if, for all

k [x, x],
FA (k) FB (k)
which means that, k [x, x], Pr (xA k) Pr (xB k)
I Example 1: compare these two lotteries: x1 N (, ) and
x2 N ( + h, ), with h > 0.
I Example 2: compare these two lotteries: x1 N (, ) and
x2 N ( + h, a), with h > 0, a > 1.
1
)

0
[ [

Applies to all increasing u, but only to a few lotteries
I Intuitive interpretation: shift in probability weights.

I Criterion which applies to all economic agents who prefer
more money to less (whether they are risk averse or not), but
which only enables to compare a narrow subset of lotteries. . .
I FOSD is not the same as state-by-state dominance. Example:
the payoffs are given (say, $1, $2, $3), and different lotteries
offer these payoffs with different probabilities we may have
FOSD, but not state-by-state dominance.
White noises
A pure, zero-mean risk
I Which changes in risk (i.e., in the probability distribution of

the payoff) decrease the expected utility of the lottery for all
risk averse agents?
I Consider two lotteries:
I Lottery A yields 1 with proba 0.5 and 3 with proba 0.5.
I Lottery B yields 1 with proba 0.5, 2 with proba 0.25, and 4
with proba 0.25.
I Same expected payoff (2).
I Lottery B is a compound lottery: playing lottery B is
equivalent to playing lottery A and another lottery with
zero-mean. It is equivalent to adding a white noise to lottery
A.
White noises
Risk averse agents are averse to white noises
I Adding a white noise (lottery with zero mean) to any lottery
reduces the expected utility of all risk averse agents.
I Another example:

Ex E u(x + ) < Ex u(x + E[
]) = Ex u(x)
The inequality follows once again from Jensen inequality.
I Whenever we need to compare two lotteries, can we show that
one lottery is equal to the other compounded by a white
noise?
I |x = x] = 0 x):
Two types of white noises (in any case, E [
I The existence of the white noise is conditional on the
outcome x of the first lottery example on the preceding
slide.
I The existence of the white noise is unconditional on the
outcome x of the first lottery example on this slide.
Mean-preserving spread
A change in risk that preserves the expected payoff
I Mean-preserving spread: spreading the probability distribution

in such a way as to leave the expected payoff unchanged.
Example: from x N (a, 2 ) to x N (a, b 2 ) b > 1.
I xb is a mean-preserving spread of xa if (i) E [xb ] = E [xa ], and
(ii) there exists an interval X such that fb (x) fa (x) for all
x X and fb (x) fa (x) for all x
/ X.
I Whenever we need to compare two lotteries, can we show that
one lottery is a mean-preserving spread of the other?
Mean-preserving spread: normal distributions

Fb (with = 2) is a MPS of Fa (with = 1)
sigma=1
sigma=2
-3 -2 -1 0 1 2 3
sigma=1
sigma=2
-3 -2 -1 0 1 2 3
Mean-preserving spread and second-order stochastic

dominance (1)
I Assume that FB is a mean-preserving spread (MPS) of FA .
This implies, by definition of a MPS:
Z x
x[fB (x) fA (x)]dx = 0 (1)
x
I Integrate by parts the LHS, remembering that

Z x h ix Z x
0
w (x)v (x)dx = w (x)v (x) w (x)v 0 (x)dx
x x x
I Here, set w 0 (x) = fB (x) fA (x) and v (x) = x. We get

Z x h ix Z x
x[fB (x)fA (x)]dx = [FB (x)FA (x)]x [FB (x)FA (x)]dx
x x x
(2)

dominance (2)
I The first term on the RHS is equal to zero. Combining (2)
with (1), if FB is a MPS of FA , then
Z x
[FB (x) FA (x)]dx = 0
x
I Also, if FB is a MPS of FA , then
Z x
S(x) = [FB (z) FA (z)]dz 0 x (3)
x
I This is the notion of second-order stochastic dominance.
I Definition: FA second order stochastically dominates FB if
and only if
Z x Z x
FA (z)dz FB (z)dz x
x x

dominance (3)
I Why is it the case? Let us calculate expected utilities:
Z x
E [u(xi )] = u(x)fi (x)dx
x
I Integrating by parts (set w 0 (x) = fi (x) and v (x) = u(x))

h ix Z x
E [u(xi )] = u(x)Fi (x) u 0 (x)Fi (x)dx
x x
I Since FA (x) = FB (x) = 0 and FA (x) = FB (x) = 1, we get

Z x
E [u(xB )] E [u(xA )] = u 0 (x)[FB (x) FA (x)]dx (4)
x

dominance (4)
I Integrate by parts equation (4), with

w 0 (x) = S 0 (x) = [FB (x) FA (x)] (see (3)) and
v (x) = u 0 (x).
h ix Z x
0
E [u(xB )] E [u(xA )] = u (x)S(x) + u 00 (x)S(x)dx
x x
I But the first term is zero since S(x) = S(x) = 0.

I Finally,
Z x
E [u(xB )] E [u(xA )] = u 00 (x)S(x)dx (5)
x

dominance (5)
I If FB is a MPS of FA , then S(x) > 0 for all x, (see Eq.(3)).

Hence, FA second order stochastically dominates FB .
I We have shown that if FB is a MPS of FA , then FA
second-order stochastically dominates FB :
E [u(xA )] > E [u(xB )]
for all risk averse agents.

I The second order stochastic dominance criterion requires one
more assumption (u 00 < 0, not too far-fetched!) but it enables
to compare more probability distributions than the first order
stochastic dominance criterion.
Second order stochastic dominance

Applies to all increasing and concave u
If two probability distributions FA and FB have the same mean,
then the following four statements are equivalent:
I All risk averse agents (u 0 > 0, u 00 < 0) prefer lottery A to
lottery B:
E [u(xA )] > E [u(xB )]
I FA second order stochastically dominates FB : for any
x [x, x], Z x Z x
FA (z)dz FB (z)dz
x x
I FB is obtained by applying a sequence of MPS to FA .
I The random variable xB is obtained by adding a white noise
to xA :
|xA = x] = 0 for any x
xB = xA + where E [
.
Diversification
Its good for you
I If x and y are two i.i.d. random variables, then
1 1
z x + y
2 2
is a reduction in risk with respect to x (i.e., x is a MPS of z)
I See section 2.1.4. of the textbook.
I All risk averse agents prefer to reduce risks by diversifying.
I Suppose the CAPM holds. Compare holding the market
portfolio (with an arbitrarily large number of assets) to
holding only one asset with a of 1. Is the latter a MPS of
the former?
I Indexing, international diversification, diversification into
alternative asset classes.
I What about risk loving gamblers?
Aversion to downside risk
I Do you prefer your wealth to be random when you are wealthy

or when you are poor?
I With lottery La , you have 1000 + with probability 0.5 and
2000 with probability 0.5.
I With lottery Lb , you have 1000 with probability 0.5 and
2000 + with probability 0.5.
I Experiments: people tend to prefer lottery Lb : aversion to
downside risk.
Aversion to downside risk and prudence

I Suppose that a lottery pays off z1 < z2 < < zn , where
each state i occurs with probability n1 . For a given state i
(1 i < n), a second independent lottery with zero-mean
payoff is added to the payoff zi . Then the expected utility is
1 X1
Vi E[u(zi + )] + u(zk )
n n
k6=i
I Would adding the second lottery to the first in state j > i

instead of i raise the agents expected utility? This is the case
if and only if Vj > Vi .
n(Vj Vi ) = E[u(zj + )] E[u(zi + )] (u(zj ) u(zi ))

Z zj
E[u 0 (x + )] u 0 (x) dx

n(Vj Vi ) =
zi
Aversion to downside risk and prudence

I Vj > Vi for any collection of {zi }i=1,...n if and only if
E[u 0 (x + )] > u 0 (x)
for any x (since zj zi can be arbitrarily small).
I E[u 0 (x + )] > u 0 (x) for any x if and only u 000 > 0.
I Definition: An agent is prudent if and only if adding a
zero-mean risk to his future wealth increases his optimal level
of savings.
I Proposition: An agent is prudent if and only if u 000 > 0.
I Proposition: the agent is prudent if and only if he is averse
to downside risk.
I Prudence precautionary motive for saving.
I Impact of market incompleteness (cannot trade certain risks)
on the savings rate, and on the equilibrium risk-free rate.
I Impact of an increase in the volatility of the economic
environment.
Aversion to downside risk and third order stochastic

dominance
Extra material, optional
I Consider an agent who is risk averse and prudent

(u 0 > 0, u 00 < 0, and u 000 > 0).
I This agent prefers the probability distribution Fa to Fb if and
only if Z x Z x
zdFa (z) zdFb (z)
x x
and
Z x Z y
Fb (z) Fa (z) dz dy 0 x [x, x]
x x
I Third order stochastic dominance.

Downside beta
Chen Ang Xing (RFS 2006)
I Break down a stocks beta into its upside beta, + (= stock

conditional on the market return being above average), and
its downside beta, (= stock conditional on the market
return being below average).
I Stocks strongly exposed to downside risk strongly covary with
the market when the market falls.
I Investors more sensitive to downside risk require a higher
expected return for holding assets with a large exposure to
downside risk.
I Sort stocks into portfolios according to their , then compute
average returns on these portfolios.
Downside beta: the results

Chen Ang Xing (RFS 2006)
portfolio return
low 3.5%
high 14.0%
low 2.7%
high 14.5%
low + 5.7%
high + 9.8%
Several degrees of risk increases

To summarize. . .
I Second-degree risk increase: mean-preserving spread.

Implies a higher variance.
I Third-degree risk increase: increase in downside risk, i.e.,
dispersion transfer from higher to lower levels of wealth, which
leaves mean and variance unchanged. Implies a lower
skewness.
I Fourth-degree risk increase: increase in outer risk, i.e.,
dispersion transfer from the center of the distribution to its
tails, which leaves mean, variance, and skewness unchanged.
Implies a higher kurtosis.
Taking multiple risks
I Suppose that I offer you the following gamble: I will toss a

fair coin, you earn $110 if its heads, you lose $100 if its tails.
I Do you accept this bet?
I Does your attitude change if you bet twice instead (on the
same bet)? What about a hundred times?
Taking multiple risks
I Be careful not to misinterpret the law of large numbers.

I Risk is reduced if instead of being exposed to one risk of size
1, the agent is exposed to n i.i.d. risks of size n1 .
I Risk is not reduced if the agent is exposed to two (or a
hundred) sources of risk instead of one.
I In the example above, the gamble would become more
appealing if the size of the bet diminished in proportion to the
number of bets: for n bets, the gain (resp. loss) on each bet
would be 110 100
n (resp. n ).
I In this case with the subdivision of the bet size, in the limit,
as the number of bets n tends to infinity, the law of large
numbers indeed applies and the average net gain approaches
$5.
The tempering effect of background risk

I Intuitively, being exposed to one risk should lower the
willingness of an economic agent to bear another risk.
I Definition: Preferences are characterized by risk
vulnerability if the presence of an exogenous background risk
with nonpositive mean (including a pure risk) increases the
aversion to other independent risks.
I Definition: Risk aversion is standard if absolute risk
aversion and absolute prudence are decreasing with wealth.
I Proposition 1: Standardness is a sufficient condition for
risk vulnerability.
I Proposition 2: Preferences are risk vulnerable if absolute
risk aversion is decreasing and convex. (The Proof follows)
I This condition means that the risk premium is decreasing with
wealth at a decreasing rate.2 In particular, absolute risk
aversion is decreasing and convex with CRRA utility.
2
Notice that absolute risk aversion cannot be positive, decreasing and
Proof of the second Proposition

I Preferences are risk vulnerable iff the indirect utility function
v (z) E [u(z + x)] is more concave than u(z), for any risk x
with nonpositive mean:
E [u 00 (z + x)] u 00 (z)
for all z
E [u 0 (z + x)] u 0 (z)
E [A(z + x)u 0 (z + x)] A(z)E [u 0 (z + x)] for all z
I To get this result, first note that DARA implies that
cov (A(z + x), u 0 (z + x)) 0 so that
E [A(z + x)u 0 (z + x)] E [A(z + x)]E [u 0 (z + x)]

I Furthermore, if absolute risk aversion is convex, then Jensen
inequality implies that
E [A(z + x)] A(z + E [x]) A(z)

The tempering effect of background risk: implications and

applications
I What is the impact on risk taking (and on the market price of

risk) of introducing or raising healthcare insurance,
unemployment insurance, disability insurance?
I What about a change in the probability of a deep recession
which would significantly lower labor incomes and raise the
probability of unemployment?
I What about a terrorist threat, the possibility of a pandemic,
or of a shortage of food or water?
I The Great Moderation and the market price of risk from 2003
to Q2 2007.
Exercises
Homework
I 2.1
I 2.5
I Exercises on zonecours.
I Acknowledgements: Some sources for this series of slides

include:
I The slides of Martin Boyer, for the same course at HEC
Montreal.
I Asset Pricing, by John H. Cochrane.
I Finance and the Economics of Uncertainty, by Gabrielle
Demange and Guy Laroque.
I The Economics of Risk and Time, by Christian Gollier.

TMC Lecture2

Încărcat de

Informații document

Drepturi de autor

Formate disponibile

Partajați acest document

Partajați sau inserați document

Opțiuni de partajare

Vi se pare util acest document?

Este necorespunzător acest conținut?

Drepturi de autor:

Formate disponibile

TMC Lecture2

Încărcat de

Drepturi de autor:

Formate disponibile

Risk and lotteries 1st order SD White noises 2nd order SD Aversion to downside risk Background risk

Lecture 2: Risk preferences and stochastic

Preferences and utility functions

The risk-return tradeoff

I Lotteries cannot be compared on the basis of their respective

s = 1 (proba = 0.5) s = 2 (proba = 0.5)

E [u(xA )] > E [u(xB )]

for all u with certain characteristics (to be defined). Then we

I State-by-state dominance: the payoff of lottery A is higher

First order stochastic dominance

I FA first order stochastically dominates FB if and only if, for all

First order stochastic dominance

First order stochastic dominance

I Intuitive interpretation: shift in probability weights.

I Which changes in risk (i.e., in the probability distribution of

I Mean-preserving spread: spreading the probability distribution

Mean-preserving spread: normal distributions

Mean-preserving spread and second-order stochastic

I Integrate by parts the LHS, remembering that

I Here, set w 0 (x) = fB (x) fA (x) and v (x) = x. We get

Mean-preserving spread and second-order stochastic

Mean-preserving spread and second-order stochastic

I Integrating by parts (set w 0 (x) = fi (x) and v (x) = u(x))

I Since FA (x) = FB (x) = 0 and FA (x) = FB (x) = 1, we get

Mean-preserving spread and second-order stochastic

I Integrate by parts equation (4), with

I But the first term is zero since S(x) = S(x) = 0.

Mean-preserving spread and second-order stochastic

I If FB is a MPS of FA , then S(x) > 0 for all x, (see Eq.(3)).

E [u(xA )] > E [u(xB )]

for all risk averse agents.

Second order stochastic dominance

Aversion to downside risk

I Do you prefer your wealth to be random when you are wealthy

Aversion to downside risk and prudence

I Would adding the second lottery to the first in state j > i

n(Vj Vi ) = E[u(zj + )] E[u(zi + )] (u(zj ) u(zi ))

Aversion to downside risk and prudence

Aversion to downside risk and third order stochastic

I Consider an agent who is risk averse and prudent

I Third order stochastic dominance.

I Break down a stocks beta into its upside beta, + (= stock

Downside beta: the results

Several degrees of risk increases

I Second-degree risk increase: mean-preserving spread.

Taking multiple risks

I Suppose that I offer you the following gamble: I will toss a

Taking multiple risks

I Be careful not to misinterpret the law of large numbers.

The tempering effect of background risk

Proof of the second Proposition

E [A(z + x)u 0 (z + x)] E [A(z + x)]E [u 0 (z + x)]

E [A(z + x)] A(z + E [x]) A(z)

The tempering effect of background risk: implications and

I What is the impact on risk taking (and on the market price of

I Acknowledgements: Some sources for this series of slides

S-ar putea să vă placă și

n(Vj Vi ) = E[u(zj + )] E[u(zi + )] (u(zj ) u(zi ))