LECTURE 2 :

UTILITY AND RISK

AVERSION

(Asset Pricing and Portfolio Theory)

Contents

 Introduction to utility theory

 Relative and absolute risk aversion
 Different forms of utility functions
 Empirical evidence
 How useful are the general findings ?
– Equity premium puzzle
– Risk free rate puzzle
Introduction

 Many different investment opportunities

with different risk – return
characteristics
 General assumption : ‘Like returns,
dislike risk’
 Preferences of investors (like more to
less)
Risk Premium and Risk
Aversion
 Risk free rate of return :
rate of return which can be earned with certainty (i.e s = 0).
3 months T-bill
 Risk premium :
expected return in excess of the risk free rate (i.e. ERp – rf)
 Risk aversion :
– measures the reluctance by investors to accept (more) risk
– ‘High number’ : risk averse
– ‘Low number’ : less risk averse
 Example : ERp - rf = 0.005 A s2p
A = (ERp - rf) / (0.005 s2p)
Indifference Curves
(Investor’s Preferences)

Indifference curve

Asset Q

ERp
Asset P

sp s
Risk and Return (US Assets
: 1926 – 1998) (% p.a.)
20

18
Small Company Stocks
16

14

12
Large Company Stocks
10
ER Long Term
8
T-bonds
6
Medium Term T-bonds
4

2
Treasury Bills
0
0 5 10 15 20 25 30 35 40 45

Standard deviation
Expected Utility

 Suppose we have a random variable,

end of period wealth with ‘n’ possible
outcomes Wi with probabilities pi
 Utility from any wealth outcome is
denoted U(Wi)

E[U(W)] = SpiU(Wi)
Example : Alternative
Investments
Investment A Investment B Investment C
Outcome Prob Outcome Prob Oucome Prob

20 3/15 19 1/5 18 ¼

18 5/15 10 2/5 16 ¼

14 4/15 5 2/5 12 ¼

10 2/15 8 ¼

6 1/15
 Example : Alternative
Investments (Cont.)
 Assume following utility function :
U(W) = 4W – (1/10) W2

– If outcome is 20, U(W) = 80 – (1/10) 400 = 40

– …

– Expected Utility
 Investment A : E(UA) = … = 36.3
 Investment B : E(UB) = … = 26.98
 Investment C :
E(UC) = 39.6(1/4) + 38.4(1/4) + 33.6(1/4) + 25.6(1/4) = 34.3
Utility Function :
U(W) = 4W – (1/10)W2

45

40

35

30

25
U(W)

20

15

10

0
0 5 10 15 20 25

W
Example : Alternative
Investments (Cont.)
 Ranking of investments remains
unchanged if
– a constant is added to the utility function
– the utility function is scaled by a constant

Example :
a + bU(W) gives the same ranking as U(W)
 Fair Lottery
 A fair lottery is defined as one that has expected value of
zero.
 Risk aversion applies that an individual would not accept
a ‘fair lottery’.
 Concave utility function over wealth
 Example :
– tossing a coin with $1 for WIN (heads) and -$1 for LOSS (tails).
x = k1 with probability p
x = k2 with probability 1-p
E(x) = pk1 + (1-p)k2 = 0
k1/k2 = -(1-p)/p or p = -k2/(k1-k2)
– Tossing a coin : p = ½ and k1 = -k2 = $ 1.-
Utility : The Basics
Utility Functions
 More is preferred to less :
U’(W) = ∂U(W)/∂W > 0
 Example :
– Tossing a (fair) coin (i.e. p = 0.5 for head)
– gamble of receiving £ 16 for a ‘head’ and £ 4 for
‘tails’
– EW = 0.5 (£ 16) + 0.5 (£ 4) = £ 10
– If costs of ‘gamble’ = £ 10.-  EW – c = 0
– How much is an individual willing to pay for playing
the game ?
Utility Functions (Cont.)

 Assume the following utility function

U(W) = W1/2

 Expected return from gamble

E[U(W)] = 0.5 U(WH) + 0.5 U(WT)
= 0.5 (16)1/2 + 0.5(4)1/2 = 3
Monetary Risk Premium
Utility
U(16) = 4
U(W)= W1/2
U(EW) = 101/2 =3.162
p
E[U(W)] = 3 A
=0.5(4)+0.5(2)

U(4) = 2

0
4 EW=10 16 Wealth
(W–p) = 9
Degree of Risk Aversion

 An individual’s degree of risk aversion

may depend on
– Initial wealth
 Example : Bill Gates or You !
– Size of the bet
 Risk neutral for small bets : i.e. Cost £ 10.-
 Gamble : Win £ 1m or £0. Would you pay £
499,999 (being risk averse) ?
Absolute and Relative Risk
Aversion
Utility Theory

 Assumptions
– Investor has wealth W and security with outcome
represented by the random variable Z
– Let Z be a fair game E(Z) = 0 and E[Z–E(Z)]2 = sz2
– Investor is indifferent between choice A and B

Choice A Choice B
W+Z Wc
E[(U(W + Z)] = EU(Wc) = U(Wc)
Utility Theory (Cont.)
 Define p = W – Wc is the max. investor is willing to pay
to avoid gamble. Measurement of investor’s absolute
risk aversion.

(1.) Expanding U(W + Z) in a Taylor series expansion around W

U(W+Z)  U(W) + U’(W)[(W+Z)-W]

+ (½) U’’(W)[(W+Z)-W]2 + …

E[U(W+Z)] = E[U(W)] + U’(W)E(Z) + (½) U’’(W)E(Z-0)2

E[U(W+Z)] = U(W) + (½) U’’(W) sz2
Utility Theory (Cont.)
(2.) Expanding U(W - p) in a Taylor series expansion around W

U(Wc) = U(W – p)  U(W) + U’(W)[(W-p)-W] + …

U(Wc) = U(W) + U’(W)(-p)

Rem. : E(U(W + Z)) = U(Wc)

 U(W) + (½) U’’(W) sz2 = U(W) + U’(W)(-p)

Rearranging p = -½ sz2 [U’’(W)] / [U’(W)]

Hence : A(W) = -U’’(W) / U’(W)

 Relative Risk Aversion
 Percentage ‘insurance premium’ is p = (W-Wc)/W Or Wc = W(1-p)
 Z is now outcome per Dollar invested WZ
 Let E(Z) = 1 and E(Z – E(Z))2 = sz2

Choice A Choice B
WZ = Wc

Applying a Taylor series expansion :

(1.) U(WZ) = U(W) + U’(W)(WZ–W) + (U’’(W)/2) (WZ-W)2 + …

Taking expectations and using the assumptions

EU(WZ) = U(W) + 0 + (U’’(W)/2) [W2sz2]

 Relative Risk Aversion
(Cont.)
(2.)
U(Wc) = U[W(1 – p)]
= U(W) + U’(W)[W(1 – p) – W] + …
U(Wc) = U(W) + U’(W) (-pW)

U(W) + ½ U’’(W) sz2 W2 = U(W) – pWU’(W)

p = -(sz2 /2) [WU’’(W) / U’(W)]

Hence : R(W) = -WU’’(W) / U’(W)

Summary : Attitude
Towards Risk
 Risk Averse
Definition : Reject a fair gamble
U’’(0) < 0
 Risk Neutral
Definition : Indifferent to a fair game
U’’(0) = 0
 Risk Loving
Definition : Selects a fair game
U’’(0) > 0
Utility Functions : Graphs

Utility U(W) Risk Neutral

Risk Averter

U(16)
U(10)

U(4) Risk Lover

4 10 16 Wealth
Indifference Curves in
Risk – Return Space

Risk Averter
Expected Return

Risk Lover

Risk Neutral

Risk, s
Examples of Utility
Functions
Utility Function : Power

 Constant Relative Risk Aversion

 U(W) = W(1-g) / (1-g) g > 0, g ≠ 1

 U’(W) = W-g
 U’’(W) = -gW-g-1

 RA(W) = g/W
 RR(W) = g (a constant)
Utility Function :
Logarithmic
 As g  1, logarithmic utility is a limiting case
of power utility

 U(W) = ln(W)
 U’(W) = 1/W
 U’’(W) = -1/W2

 RA(W) = 1/W
 RR(W) = 1
Utility Function :
Quadratic
 U(W) = W – (b/2)W2 b>0
 U’(W) = 1 – bW
 U’’ = -b

 RA(W) = b/(1-bW)
 RR(W) = bW / (1-bW)

 Bliss point : W < 1/b

Utility Function : Negative
Exponential
 Constant Absolute Risk Aversion

 U(W) = a – be-cW c>0

 RA(W) = c
 RR(W) = cW
Empirical Evidence
How does it Work in the
‘Real World’ ?
 To investigate whether (specific) utility
functions represent behaviour of
economic agents :
– Experimental evidence from simple choice
situations
– Survey data on investor’s asset choices
Empirical Studies
 Blume and Friend (1975)
– Data : Federal Reserve Board survey of financial
characteristics of consumers
– Findings : Percentage invested in risky asset
unchanged for investors with different wealth
 Cohn et al (1978)
– Data : Survey data from questionnaires (brokers
and its customers)
– Findings : Investors exhibit decreasing relative
RA and decreasing absolute RA
Coefficient of Relative
Risk Aversion (g)
 From experiments on gambles coefficient of
relative risk aversion (g) is expected to be in
the range of 3–10.
 S&P500
Average real return (since WW II) 9% p.a. with SD
16% p.a.
C-CAPM suggests coefficient of relative risk aversion
(g) of 50.
 Equity Premium Puzzle
Is g = 50 Acceptable ?
 Based on the C-CAPM
 For g = 50, risk free rate must be 49%
 Cochrane (2001) presents a nice example
– Annual earnings $ 50,000
– Annual expenditure on holidays (5%) is $ 2,500
– Rft ≈ (52,500/47,500)50 – 1 = 14,800% p.a.
– Interpretation : Would skip holidays this year
only if the risk free rate is 14,800% !
How Risk Averse are You ?

 Investigate the plausibility of different

values of g to examine the certainty
equivalent amount for various bets.

 Avoiding a fair bet (i.e. win or lose $x)

– Power utility
– Initial consumption : $ 50,000
Avoiding a Fair Bet !
Amount Risk Aversion g
of Bet
($) 2 10 50 100 250
10 0.002 0.01 0.05 0.1 0.25

100 0.2 1 5 9.9 24

1,000 20 99 435 655 863

10,000 2,000 6,920 9,430 9,718 9,888

20,000 8,000 17,600 19,573 19,789 19,916

Application : Mean
Variance Model
Mean-Variance Model and
Utility Functions
 Investors maximise expected utility of end-of-period
wealth
 Can be shown that above implies maximise a function
of expected portfolio returns and portfolio variance
providing
– Either utility is quadratic, or
– Portfolio returns are normally distributed (and utility is
concave)

 W = W0(1 + Rp)
 U(W) = U[W0(1 + Rp)]
Mean-Variance Model and
Utility Functions (Cont.)
Expanding U(Rp) in Taylor series around mean of Rp (=mp)
 U(Rp) = U(mp) + (Rp – mp) U’(mp)
+ (1/2)(Rp – mp)2 U’’(mp)
+ higher order terms

 Taking expectations
E[U(Rp)] = U(mp) + (1/2) s2p U’’(mp) +E(higher-terms)

– E[U(Rp)] is only a function of the mean and variance

– Need specific utility function to know the functional
relationship between E[U(Rp)] and (mp, sp) space
Summary

 Utility functions, expected utility

 Different measures of risk aversion :
absolute, relative
 Attitude towards risk, indifference
curves
 Empirical evidence and an application
of utility analysis
References

 Cuthbertson, K. and Nitzsche, D.

(2004) ‘Quantitative Financial
Economics’, Chapter 1
References
 Blume, M. and Friend, I. (1975) ‘The Asset Structure
of Individual Portfolios and Some Implications for
Utility Functions’, Journal of Finance, Vol. 10(2), pp.
585-603
 Cohn, R., Lewellen, W., Lease, R. and Schlarbaum, G.
(1975) ‘Individual Investor Risk Aversion and
Investment Portfolio Composition’, Journal of Finance,
Vol. 10(2), pp. 605-620.
 Cochrane, J.H. (2001) Asset Pricing, Princeton
University Press
END OF LECTURE