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x C1 Risk 3
Probability
• probability of an event occurring is the relative
frequency with which the event occurs
• if αi = the probability of event i occurring and there
are n possible events (states) then
• 1. αi > 0, i = 1…n
• 2. ‘i=1αi = 1
n
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Example 2
• Gamble (X) flip of a coin
• if heads, you receive $10 X1 = +10
• if tails, you pay $1 X2 = -1
• if you play this game many times, you will be a big winner
• How much would you pay to play this game:
• perhaps as much as a $4.50
• But of course the answer depends upon your preference to risk
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Fair Gambles
• if
the cost to play = expected value of
these gambles the outcome
1 i
E(X) = i xi 2i
2
i 1
1
Paradox: no one would pay an “actuarially fair” price to play this game
(no one would even pay close to the fair price)
8
Explaining the St. Petersburg Paradox
• this paradox arises because individuals do not make
decisions based purely on wealth, but rather on the utility of
their expected wealth
• if we can show that the marginal utility of wealth declines
as we get more wealth, then we can show that the expected
value of a game is finite
• Assume U(X) = ln(X) U'(X)=1/x > 0 MU positive
• U"(X)=-1/x2 < 0 Diminishing MU
• E(U(W)) = E(‘i=1αi U(Xi)) = ( α‘i=1i ln(Xi)) = 1.39 <
• the following five axioms of cardinal utility provide the minimum set
of conditions for consistent and rational behaviour
10
5 Axioms of Choice under uncertainty
A1.Comparability (also known as completeness).
For the entire set of uncertain alternatives, an individual can say
either that
either x is preferred to outcome y (x > y)
or y is preferred to x (y > x)
or indifferent between x and y (x ~ y).
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5 Axioms of Choice under uncertainty
A4.Measurability. (CARDINAL UTILITY)
If outcome y is less preferred than x (y < x) but more than z (y > z),
In Maths,
if x > y > z or x > y > z ,
then there exists a unique α such that y ~ G(x,z:α)
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5 Axioms of Choice under uncertainty
A5.Ranking. (CARDINAL UTILITY)
or if α1 = α2, then y ~ u
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One more assumption
• People are greedy, prefer more wealth than
less.
• The 5 axioms and this assumption is all we
need in order to develop a expected utility
theorem and actually apply the rule of
max E[U(W)] = max ∑iαiU(Wi)
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Utility Functions
• Utility functions must have 2 properties
• Remark:
Utility functions are unique to individuals
- there is no way to compare one individual's utility function with
another individual's utility
- interpersonal comparisons of utility are impossible
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if we give 2 people $1,000 there is no way to determine who is happier
One more element: Risk Aversion
• Consider the following gamble:
• Prospect a prob = α G(a,b:α)
• prospect b prob = 1-α
• would you prefer the $10 for sure or would you prefer the gamble?
U(b)
U(b)
U(b) U(a)
U(a)
U(a)
a b W a b W a b W
Risk Preferring Risk Neutral Risk Aversion
U'(W) > 0 U'(W) > 0 U'(W) > 0
U''(W) > 0 U''(W) = 0 U''(W) < 0
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The Utility Function
U(W)
3.40
3.00
U'(W) > 0
U''(W) < 0
1.61
U'(W) = 1/w
U''(W) = - 1/W2
MU positive
But diminishing
0 W
1 5 10 20 30 19
U[E(W)] and E[U(W)]
• U[(E(W)] is the utility associated with the known
level of expected wealth (although there is
uncertainty around what the level of wealth will
be, there is no such uncertainty about its expected
value)
• E[U(W)] is the expected utility of wealth is utility
associated with level of wealth that may obtain
• The relationship between U[E(W)] and E[U(W)] is
very important
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Expected Utility
• Assume that the utility function is natural logs: U(W) = ln(W)
• Then MU(W) is decreasing
• U(W) = ln(W)
• U'(W)=1/W
• MU>0
• MU''(W) < 0 => MU diminishing
U[E(W)] = 2.30
U[E(W)] = U(10) = 2.30
E[U(W)]
E[U(W)] = 1.97 = 0.8*U(5) + 0.2*U(30)
= 0.8*1.61 + 0.2*3.40
1.61 = 1.97
Therefore, U[E(W)] > E[U(W)]
Uncertainty reduces utility
0 W
1 5 CE
= 7.17 10 30 22
The Certainty Equivalent
• The Expected wealth is 10
• The E[U(W)] = 1.97
• How much would this individual take with
certainty and be indifferent the gamble
• Ln(CE) = 1.97
• Exp(Ln(CE)) = CE = 7.17
• This individual would take 7.17 with certainty
rather than the gamble with expected payoff of 10
• The difference, (10 – 7.17 ) = 2.83, can be viewed
as a risk premium – an amount that would be paid
to avoid risk
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The Risk Premium
• Risk Premium:
– the amount that the individual is willing to give up in order to avoid the
gamble
Suppose the individual has the choice now between the gamble and the
expected value of the gamble
E[U[W)] = 1.97
Certainty equivalent = $7.17
Investor would be willing to pay a maximum of $2.83 to avoid the gamble
($10 - $7.17) ie will pay an insurance premium of $2.83.
THIS IS CALLED THE MARKOWITZ PREMIUM
In general,
if U[E(W)] > E[U(W)] then risk averse individual (RP > 0)
if U[E(W)] = E[U(W)] then risk neutral individual (RP = 0)
if U[E(W)] < E[U(W)] then risk loving individual (RP < 0)
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The Arrow-Pratt Premium
• Risk Averse Investors
• assume that utility functions are strictly concave and increasing
• Individuals always prefer more to less (MU > 0)
• Marginal utility of wealth decreases as wealth increases
W = current wealth
gamble Z and the gamble has a zero expected value
E(Z) = 0
what risk premium (W,Z) must be added to the gamble to make the individual
indifferent between the gamble and the expected value of the gamble?
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The Arrow-Pratt Premium
The risk premium can be defined as the value that satisfies the following
equation:
LHS: RHS:
expected utility of utility of the current level of wealth
the current level plus
of wealth, given the the expected value of
gamble the gamble
less
the risk premium
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Relative Risk Aversion
• Constant RRA => An individual will have constant risk aversion to a
"proportional loss" of wealth, even though the absolute loss increases
as wealth does
• Define RRA as a measure of Relative Risk Aversion
U (W)
RRA = - W *
U (W)
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Quadratic Utility
Quadratic Utility - widely used in the academic literature
U(W) = a W - b W2
-U"(W) 2b
ARA = --------- = ---------
U'(W) a -2bW
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An Example
• U=ln(W) W = $20,000
• G(10,-10: 50) 50% will win 10, 50% will
lose 10
• What is the risk premium associated with
this gamble?
• Calculate this premium using both the
Markowitz and Arrow-Pratt Approaches
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Arrow-Pratt Measure
• = -(1/2) 2z U''(W)/U'(W)
• 2z = 0.5*(20,010 – 20,000)2 + 0.5*(19,090 – 20,000)2 = 100
• U'(W) = (1/W) U''(W) = -1/W2
• U''(W)/U'(W) = -1/W = -1/(20,000)
33
Markowitz Approach
• E(U(W)) = piU(Wi)
• E(U(W)) = (0.5)U(20,010) + 0.5*U(19,990)
• E(U(W)) = (0.5)ln(20,010) + 0.5*ln(19,990)
• E(U(W)) = 9.903487428
• ln(CE) = 9.903487428 CE = 19,999.9975
• The risk premium RP = $0.0025
• Therefore, the AP and Markowitz premia are the
same
34
Markowitz Approach
E(U(W))
= 9.903487
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Mean & Variance as choice variables
• With 5 axioms, prefer more to less, we
have Expected utility theorem
• With risk-aversion assumption, we
solve St. Petersburg’s paradox Return
• With returns of risky assets being
jointly normally distributed, we can
draw indifference curves on the plane
of return (E(r)) and risk (var(r) or
standard deviation of r) as the right
diagram Risk