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Meansofmeasurement
Colomeischi T.
Abstract This paper emphasizes an analysis concerning attitude towards risk of the economic agents in uncertainty
conditions. The paper begins with a general presentation of various approachesover concepts ofcertainty, uncertainty
andrisk.Lateron,ananalysisabouttheeconomicagentsattitudetowardsriskiscarriedout,thusdefiningtheaversion,
neutrality and predilection towards risk of the individuals by means of the utility functions. The main characteristics
thatmeasureattitudetowardsriskoftheeconomicagentsareexplainedinthethirdparagraph:thecertaintyequivalent,
theriskpremium(prize),thecoefficientofabsoluteriskaversion,thecoefficientofrelativeriskaversionandtheArrow
Prattriskpremium.
Keywords: uncertainty,risk,utilityfunction,lottery,riskaversion
1. GENERAL CONSIDERATIONS CON
CERNING THE CERTAINTY, UNCER
TAINTYANDTHERISK
2.1 Comparisonbetweenlotteries
The issue of comparing the lotteries is obviously
occurring. This comparison can be carried out in accor
dancetotwocriteria:
a. The criterion of the mathematical earnings antic
ipated value indicates the choosing of lottery with the
highest anticipated value. Thus, if
1 2
1 2
...
:
...
n
n
x x x
X
p p p
| |
|
\ .
and
1 2
1 2
...
:
...
n
n
x x x
X
p p p
' ' '
| |
'
|
' ' '
\ .
aretwolotteries,theXlotterywillbechosenif:
( ) ( ) ( ) ( )
1 1
n n
i i i i
i i
E X E X p x p x
= =
' ' ' > >
.
b. The criterion of the expected utility value, according
towhomthelotterywiththehighestmathematicalantic
ipatedvaluewillbechosen.
If : U signifies the utility function of von Neu
mann Morgenstern type (signifying that is strictly in
creasing, strictly concave and of C
2
class), the X lottery
willbechosenif:
( ) ( )
1 1
n n
i i i i
i i
p U x p U x
= =
' ' > ( (
.
2.2 The aversion, neutrality and predilection to
wardsrisk
Regardingtheattitudeoftheeconomicagenttowards
risk,thiscaninclude:
a. Risk aversion. One might say that an individual has
riskaversion(andthatwillbecalledriskphobic)ifheisnot
willing to accept a null lottery (meaning that the mathe
matical anticipated value of the gain is zero). In other
words, the utility of the wealth already held is higher
than the utility of the probable wealth that might be
achievedinthesituationoflotteryacceptance.
If one analyzes the twodimensional case, an
economical agent has risk aversion when the utility U
functionisstrictlyconcave:
( ) ( ) ( )
1 1 2 2 1 2
1 2
U p x p x p U x p U x + > +
.
The utility function for an individual with risk
aversion can be represented under the form from Figure
1.
Asexamples ofutilityfunctionsdedicatedtothe
economic agents with risk aversion, one might mention:
the radical function ( ) U x x = or the logarithmical func
tion ( ) ln U x x = .
Risk aversion is practically that determining in
dividuals to ensure against the potential damages, they
agreeingtopayinsurancebonustosomeintervals,witha
lower value than the probable value of damages in the
absenceoftheinsurance.
Figure1.Formoftheutilityfunctionforaneconomic
agentwithriskaversion
X x
2
x
1
E(X)
E(U(X))
U(x
1
)
U(x
2
)
U(X)
U(E(X))
JOURNAL OF COMPUTING, VOLUME 3, ISSUE 12, DECEMBER 2011, ISSN 2151-9617
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b. Neutrality(indifference)towardsrisk.Anindividual
willbeconsideredasneutraltowardsriskifhehasnopre
ference as regards his accept or denial as concerns a null
lottery.
As regards the twodimensional case, this signi
fiesthatthefunctionUislinear,meaning:
( ) ( ) ( )
1 1 2 2 1 1 2 2
U p x p x p U x p U x + = + .
The graphic of a utility function for a neutral
agenttowardsriskisundertheformofastraightline,as
canbeseeninFigure2:
Figure2.Formoftheutilityfunctionforaneconomic
agentregardlesstherisk
Figure3.Formoftheutilityfunctionforanindividual
ofrisktendency
Thethreeattitudestowardsriskofanindividual
can be defined and especially measured by means of the
followingparameters:
= = + =
=
.
Related to the attitude of the individual towards
risk,theriskpremiumwillbenegative,positiveornull.
Iftheagenthasriskaversion,hisutilityfunction
willbeincreasingandconcave,meaning:
( ) ( ) ( ) ( )
U E X E U X > .
Though, ( ) ( ) ( )
c
U E E U X = and according to the
abovementionedrelationship,wewillhave:
( ) ( ) ( )
c
U E X U E > .
Knowingthatthefunctionofutilityisincreasing,wewill
deductthat:
( ) 0
c X
E X E > > .
In this way, the individual with risk aversion has a positive
riskpremium,andheiswillingtosellthelotteryatalower
X x
2
x
1
E(X)
E(U(X))
U(x
1
)
U(x
2
)
U(X)
U(E(X)) =
X x
2
x
1
E(X)
E(U(X))
U(x
1
)
U(x
2
)
U(X)
U(E(X))
JOURNAL OF COMPUTING, VOLUME 3, ISSUE 12, DECEMBER 2011, ISSN 2151-9617
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price (he is known as reducing the significance of the
riskinglotteries).
As concerns an agent with risk predilection, we
willhaveafunctionofincreasingandconvexutility,thus
resulting:
( ) ( ) ( ) ( )
U E X E U X < .
Knowing that ( ) ( ) ( )
c
U E E U X = and according to
theabovementionedrelationship,wewillhave:
( ) ( ) ( )
c
U E X U E < .
KnowingthattheutilityfunctionUisincreasing,wewill
achieve:
( ) 0
c X
E X E < < .
One might say that a risk tender agent has a negative risk
premium, since he supplementary appreciates the risk of
lottery,thepriceatwhichheiswillingtobuybeinggreat
erthattheestimatedvalueofit.
For an individual being indifferent to risk, the
utilityfunctionislinearand:
( ) ( ) ( ) ( )
U E X E U X = .
Though, ( ) ( ) ( )
c
U E E U X = according to the above
mentionedrelationship,wewillhave:
( ) ( ) ( )
c
U E X U E = .
KnowingthattheutilityfunctionUisincreasing,wewill
deductthat
( ) 0
c X
E X E = = .
Therefore,anindividualofriskneutralfeaturehasanullrisk
premium, meaning that theprice at which he is willing to
buythelotteryisequaltoitsestimatedvalue.
( )
( )
( )
a
U x
r x
U x
''
=
'
.
5) TheriskpremiumofArrowPratttype
Forarandomvariableundertheformof X x e = + and
respecting some hypothesis (of average x , variance
2
o
and moments of superior order negligible as related to
thedispersion)andafunctionofutilityUstrictlyincreas
ing, strictly concave and of class C
2
, Arrow and Pratt
achieved, by Taylor series, the expression of the absolute
aversiontorisk,dependingupontheriskpremiumunder
theform:
( )
( )
( ) ( )
2
2
2 ,
1
,
2
X
a X a
x e
r x x e r x
o
o
= =
,
Here, ( ) ,
X
x e signifies the risk premium of the initial
wealth x .Inthisway,onehasreachedtoalocalparame
teroftheriskaversion,foralowleveloftherisk.
4.THEARROWPRATTTHEOREM
5.CONCLUSION
Attitude towards risk of an economic agent is
emphasized by the form of his utility function. The eco
nomicagentwillproveriskaversionwhenhisfunctionof
utilityisstrictlyconcave.Aneconomicagentwillbeindif
ferent towards risk if his utility function is linear. If the
utilityfunctionisstrictlyconvex,theagentwillhaveten
dencytowardsrisk.
By means of parameters that measure attitude
towards risk, three ways of comparing the risk aversion
those two economic agents have can be distinguished,
beingsynthesizedbytheArrowPratttheorem.
Firstly, the coefficients of the risk aversion are
determined upon basis of the utility function U, they be
ing invariant to any linear and positive transformation.
Afterwards, an intrinsic connection exists between these
coefficients and the preferences of the economic agent,
expressed by the risk premium. Finally, the risk aversion
canbedefinedasrelatedtotheutilityconcavityfunction.
REFERENCES
JOURNAL OF COMPUTING, VOLUME 3, ISSUE 12, DECEMBER 2011, ISSN 2151-9617
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