1.

Static Decision Making

Objectives: Understanding of Individual decision making under uncertainty Individual evaluation of goods with uncertain future values Behavior towards risk The concept of the risk premium Preferences on assets with normal distributed returns

Concepts Expected Utility Hypothesis Risk Averseness, Risk Neutrality, Risk Loving Markowitz Risk Premium and Certainty Equivalent Arrow-Pratt Approximation of Risk Premium Mean-Variance Preferences

Contents: 1.1 1.2 1.3 1.4 1.5 1.6 Contingent Goods Structure of the Model Expected Utility Hypothesis Behavior towards Risk Risk Premium Mean Variance Criterion

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1.1 Contingent Goods The concept of contingent goods developed by Kenneth Arrow is very useful to characterize the future value of goods in an uncertain world. In the following we apply it only to financial assets. Under certainty goods are characterized by their physical quality, by the time and the location of their availability. Under uncertainty we characterize goods additionally by the incidence of future (events that influence the future) value of goods. It is convenient to declare the incidence of a certain event as a state of the world and the future value of the good is thus contingent upon this state of the world. In this case the future value of goods is a random variable. The random variable may have finite or infinite, but numerable realizations.

Event Tree In an inter-temporal context the concept of states of the world can be presented with an event tree. The event tree represents the complete sequence of the realizations of a discrete random variable from the present to a future date.
t=3 t=2 t=1
Figure 1.1: 3-period event tree

In this graph we observe a simple example of an economy that lasts three periods and can take three randomly determined states. The random generator may influence the level of business activities at each node (yellow point) of the tree. The level of activity may be high in the left (blue) branch, medium in the middle (red) branch and low in the right (green) brunch. In this example we have 3 3 = 27 endpoints of the tree.
-

In general, if an economy lasts t = 1,T periods and the random influence generates = 1, possible outcomes in each point of realization the tree has T different endpoints. Each endpoint is associated with a complete history of random realizations from the present to a certain future date. Each endpoint of the tree is representing a state of the world at date T. There are s = 1,S of them with S = T . The complete history of these realizations is of economic relevance. Think of a sequence of good or bad economic developments.
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One Period Model We assume that in the 1-period future the economy assumes s = 1,S states of the world.
1 2 s S-1 S

t=1

Figure 1.2: 1-period event tree

Information We do not discuss any information problems. We can imagine different types information problems, such as insider information, or lower costs of public or private available information. These are very interesting topics. However, it is beyond Financial Modeling I. Value of Assets When we discuss assets we think of financial assets in most cases. However most of the insights apply also for real assets. Because of depreciation and storage costs some minor modifications and extensions are necessary. Moreover, we restrict our analysis to a one-period analysis. In this case we can characterize assets by their current and future values including (intra-period) payoffs or even more conveniently by their returns. Therefore we use the following conventions:
-

The value of an asset X at the beginning of the period is X 0 . The random future value of an asset - at the end of the current (or the beginning of the future) period is denoted as X 1 with the probability distribution g X 1 . (The

( )

circumflex is attached to random variables.)

-

In discrete presentations it is convenient to express the random future values of assets and their probability of occurrence as functions of state of the world s. In this case X 1 ( s ) denotes the future value of the asset in the state s that occurs with probability

g1 s . X
-

()

The random generator governing the future values of assets (associated with certain states of the world) may follow any probability distribution. However, many models assume that future values of assets are lognormal distributed. Lognormal, since the minimal value of a many assets stocks, plain vanilla bonds etc. is zero.

Return on Assets According to convenience the returns of assets are defined as arithmetic or geometric rate of returns. The future (gross) return RX 1 of the asset x is defined as

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X0 In some models we use the (net) rates of return, which are defined as
rX 1 RX 1 1 ln RX 1 ,

RX

X1 = 0, X

or

RX s =
1

()

X1 s

()

(1.1)

or

1 rX s R1 s 1 ln R1 s X X

()

()

()

(1.2)

As the future value of the assets is random the return is, of course, also a random variable. We express the probability distribution as f rX 1 , or f rX 1 ( s ) , respectively. The probability
functions, f rX

functions g X 1 and g X 1 s are lognormal distributed. (For the definition of normal or lognormal probability distributions see Appendix A.2)
Simplification of the Notation Utility functions can be defined on total wealth, on contingent goods, or contingent values of assets or portfolios of assets. In the second and third section we show that these insights apply to all objects of individuals preferences. Thus we omit the indication of specific goods or assets in these sections. Since we restrict our analysis to the one-period analysis during these lectures we simplify notation by omitting the time indices. To simplify notations we omit the time indices. We denote the present value of the asset x as X , and its random future values as X , or X s ,

( )

( ) and
1

f rx s , are approximately normal distributed if the probability

1

()

( )

()

and returns as RX and RX s , or X and rX s , respectively. r

()

()

()

1.3 Expected Utility Hypothesis John von Neumann and Oskar Morgenstern proved that under some specific assumptions (see Appendix A.1.3) individual preferences concerning lotteries (games) can be presented as the expected utility of the payoffs of the lottery. 1.3.1 Definitions and Concepts A twice continuously differentiable (concave) utility function u () is defined over the (future) value of the asset.
-

Future value of the asset can be grasped by a lottery (game) that is defined by the random future payoffs X and the probability function g ( X ) , or in a state depending

presentation by X ( s ) = X (1) ,, X ( S ) and g X = g X 1 ,g X 2 ,g X S . This presentation can be applied to total wealth and to future value of assets or portfolios of assets as well.
-

() ()

( )

We write a lottery (game) as G X ;g ( X ) or G X ( s ) ;g X ( s ) . For simplicity we omit the specification of the probability distribution.

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The utility of a lottery (game) presents the individual preferences over the lottery (game), i.e. U G ( X ;g ) , or U G X ( s ) ;g .

The expected utility of the lottery (game) is defined as the expected value of the utility of the payoffs of a lottery (game), i.e.
U G X ;g = E U X ;g , or
U G X s ;g = g 1 u X 1 ++ g S u X S .

{ ( ) }
()

( () )
(

()

( )

( )

(1.3)

The expected utility of a lottery (game) has to be distinguished from the utility of the expected value (of the payoffs) of the lottery (game). The latter is defined as
U E G X ;g = u E X

) } { ( )} , or
() () ( ) ( )
(1.4)

U E G X s ;g = u g 1 X 1 ++ g S X S

{ (
()

() )}

In order to present the expected utility hypothesis in a graphical exposition and a small numerical example it is recommended to introduce a binomial world with two states of the world, s = 1,2 , with the payoffs X (1) and X ( 2 ) which occur with probabilities g (1) , and
g 2 = 1 g 1 .
In order to simplify notation we express the expected value of X as X , the variance as XX ,

()

and the standard deviation as X . The expected value and the variance of these payoffs are
X = g 1 X 1 + g 2 X 2 ,

() () () ()

(1.5)

and
XX = g 1 X 1 X + g 2 X 2 X .

() ()

() ()

(1.6)

The expected utility of this game is

E U X s ; p = g 1 u X 1 + g 2 u X 2 ,

()

} ()

()

()

()

(1.7)

and the utility of the expected value is

U E X s ;g = u g 1 X 1 + g 2 X 2 = u X .

()

() () () ()

( )

(1.8)

In the subsequent graphic the expected utility is presented as a convex combination of the payoffs somewhere along the red line depending on the probabilities of the payoffs. The utility of the single payoffs and moreover the utility of the expected value of the game (lottery) are located along the utility function. If the utility function is concave the utility of the expected value must exceed the expected utility of the game (lottery).

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Static Decision Making

"!#" "#!!$"$

'"!

!"

&!%""#!!%"$%&!$""#!!$"$ "#!!%"$

!!%" &

!&&

!!$"&

Figure 1.3: Expected Utility

The expected utility of the game presented in figure 1.3 can be illustrated by a simple

numerical example. We assume that the utility function is a square root u X s = X s . Moreover we specify the payoffs of the lottery as x 1 = 100 , and x 2 = 10000 , and the

() () binomial probabilities as g (1) = 3 4 , and therefore g ( 2 ) = 1 g (1) = 1 4 . The expected

value of the game is thus X = 3 4 * 100 + 1 4 * 10000 = 2,575 . The expected utility of the game is thus defined as
E U X s ;g = 3 4 * 100 + 1 4 * 10000 = 7.5 + 25 = 32.5 .

()

()

()

The utility of the expected value of the game is

U E X s ;g = 3 4 * 100 + 1 4 * 10000 = 75 + 2500 = 2575 50.74 .

()

Obviously the utility from the game with uncertain outcomes (the expected utility) is significantly smaller than the utility from the deterministic expected value of the game. 1.3.2 An Alternative Presentation of the Expected Utility Hypothesis
Sometimes it is convenient to decompose the random variable X into expected value of E ( X ) and a lottery .

X = E X + ,

( )

(1.9)

Obviously, is a fair lottery with an expected value of zero and a constant variance equal to the variance of X :
Financial Modeling I, js Static Decision Making 7

 E = E X X = 0

()

Var = E X X E X X

()

(1.10)

} {

= E X E X

( )

= XX .

(1.11)

In the binomial case with two states, s = 1,2 , and the probabilities g s the values of the assets deviate from its mean by ( s ) . The asset value can be presented by the sum of the expected value of the initial game plus the game of the stochastic deviations. The expected value and the variance of the initial game can be expressed as
E X + = X + g 1 1 + g 2 2 = X ,

()

() () () ()

(1.12)

and

Var X + = g 1 X + 1 X + g 2 X + 2 X
2 2

() () = g (1) (1) + g ( 2 ) ( 2 )
() ()

()

()

(1.13)

Thus the expected utility of the game can be expressed as

E u X + G 1 , 2 ;g = g 1 u X + 1 + g 2 u X + 2 .

()

()

()

()

(1.14)

Also this version of the expected utility can be illustrated graphically:

"!!"##$
!%

"!

"$#$

&'"%#"! %&'"$#"!

!%

"%#$ !% "$#$

&"" "!
!%

!#

"%#$

& !% "%#

!&&

!%

"$#

Figure 1.4: Expected Utility Fair Game

In the numerical example of the previous section the stochastic deviations of the payoffs from the mean are defined as

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Static Decision Making

 1 = X 1 X = 100 2575 = 2475 ,

()

()

and
2 = X 2 X = 10000 2575 = 7425 .

()

()

Thus the mean of the deviations equals

= g 1 1 + g 2 2 = 3 4* 2475 + 1 4* 7425 = 0 .

() () () ()

1.3.3 The Existence of a von Neumann Morgenstern Utility Function If preferences are defined over the entire range of lotteries and if these preferences satisfy some specific assumptions (see Appendix A.1.3) a utility function with the following property can be defined over the range of lotteries:
U G X s ;g = E U G X s ;g g s u X s s=1

( () )

{ (

() )}

( ) ( ( ))

(1.15)

Under the von Neumann Morgenstern axiomatic, the preferences over lotteries can be represented by the expected utility of the outcomes of the lottery. 1.4 Behavior towards Risk Without explanation we used a concave utility function that implies risk averse investors. In this section we will discuss this topic explicitly. We will classify the individuals preferences, their attitudes towards risk, and the shape of the utility function. 1.4.1 Characterization of the Behavior towards Risk An individuals behavior towards risk can be classified into three categories:
-

Risk-averse behavior Risk-loving behavior Risk-neutral behavior

Risk Averse Behavior The individual is risk-averse if it prefers the expected value of the payoffs of a lottery (game) rather than the lottery itself. In terms of utilities this means the utility of the expected value of the payoffs of a lottery is greater than the utility of the lottery (game). This condition is obviously fulfilled in case of a concave utility function.
S S u X = u g s X s > g s u X + s = E u X + . s=1 s=1

() ()

()

()

(1.16)

Depending on the probabilities the expected utilities are along the red lines in the graphs below whereas the utility of the expected value is somewhere along the utility function.

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Static Decision Making

#!!"

#!!"

#!!"

!!""

!!#"

!!""

!!#"

!!""

!!#"

Figure 1.5: Utility functions of risk averse, risk loving, and risk neutral individuals

Risk Loving Behavior If the individual prefers the lottery (game) rather than the expected value of the payoffs of the lottery (game) it is a risk lover. In terms of utilities this means the utility of the expected value of the payoffs of a lottery is smaller than the utility of the lottery (game). This condition is satisfied if the utility function is convex.
S S u X = u g s X s < g s u X + s = E u X + s=1 s=1

() ()

()

()

(1.17)

Risk Neutral Behavior The individual is risk neutral if it is indifferent between the expected value of the payoffs of a lottery and the lottery itself, or, if the utility of the expected value of the payoffs of a lottery equals the utility of the lottery (game). This is the case if the utility function is linear.
S S u X = u g s X s = g s u X + s = E u X + s=1 s=1

() ()

()

()

(1.18)

1.4.2 Local measures of risk behavior In the economic analysis we use two measures of behavior towards risk:
-

Absolute Risk-Aversion (ARA) Relative Risk-Aversion (RRA)

As both ARA and RRA are local measures we should apply them only for small changes of wealth. (In this section we omit the indices of time and state of the world because risk aversion is a time independent property of the utility function rather than the random realization of future wealth.) The absolute risk-aversion is defined as:
ARA u X

( ) u ( X )

(1.19)

ARA is a measure of the curvature of the utility function. It decreases with its slope and it increases with the change of the slope.

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10

For many economic problems it is of great importance how ARA changes with increasing wealth. The answer can be seen from the derivative of ARA with respect to wealth:
d u X

dARA dX

( ) u ( X ) u ( X ) u ( X ) u ( X ) = dX u ( X )
2

(1.20)

As the denominator is positive the sign of the change of ARA is determined by the following condition:

dARA 0 dX

()

u X u X u X

( ) ( ) () ( )

(1.21)

Since u X < 0 we can rewrite the condition as follows:

( )

dARA 0 dX

()

u X

( ) u ( X ) ( ) u X u ( X ) ( )

(1.21)

Therefore absolute risk-aversion decreases with increasing wealth if the second derivative is less elastic than the first derivative of the utility function. The relative risk aversion is defined as the elasticity of the marginal utility, i.e.

RRA

u X

( ) X = ARA X u ( X )

(1.22)

In order to investigate how the relative risk aversion changes with increasing wealth we calculate its respective derivation:

u X d X u X d ARA X dRRA dARA = = = ARA + X dX dX dX dX

( ) ( )

(1.23)

u X u X + u X u X X u X X =
2

( ) ( )

dRRA 0 dX

()

( ) ( ) ( ) u ( X ) u ( X ) u ( X ) 1 X () X u ( X ) u ( X )

(1.24)

1.4.3 Two Useful Examples A constant Absolute Risk Aversion (CARA) utility function

u x = e bx
ARA x =

()

u = be bx > 0 , u = b2 e bx < 0 ,
b2 e bx =b>0 be bx
dARA x dx

()

()

(1.25) (1.26)

()

( )=0

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11

Obviously, this utility function exhibits CARA (Constant ARA).

RRA x =

()

b2 e bx x = bx > 0 be bx

dRRA x dx

( ) =b>0

(1.27)

Obviously, RRA increases with increasing outcome (goods). A Constant Relative Risk Aversion (CRRA) utility function In many models economists use an utility function with constant relative risk aversion.

u x =

()

x 1 1

with u x = x > 0 , u x = x 1 < 0 .

()

()

(1.28)

The absolute risk aversion of this utility function is therefore decreasing in x:

ARA =

x 1 1 = >0 x x

dARA 1 = 2 < 0 dW x

(1.29)

The relative risk aversion is obviously a constant

x 1 RRA = x= >0 x
1.5 Risk premium

(1.30)

The concept of the risk premium has been developed by Harry M. Markowitz. He defines the risk premium as the difference between the expected wealth of a lottery (game) and the certainty equivalence of the lottery (game), i.e. the certain amount of wealth (money) for which an individual is indifferent against the lottery. Therefore we can view the risk premium as the costs of a lottery (game). 1.5.1 Definition of the Markowitz Risk Premium

Following this idea the risk premium X , can be defined as

u X X , = E u X + ,

(1.31a)

or
S S u g s X s X , s ,g s = g s u X + s s=1 s=1

() ()

() ()

()

()

(1.31b)

The risk premium is defined as the amount of money that can be deducted from the expected value in order to equalize the utility of the residual with the expected utility of the game. The risk premium has to equalize the utility of the certainty equivalent, i.e. the difference of the expected payoffs and the risk premium, and the expected utility of the game (lottery). For the numerical example and the graphic presentation we use again the binomial simplification in the fair game version with the payoffs X (1) = X + (1) , and
X 2 = X + 2 . In this model the certainty equivalent is defined as
Financial Modeling I, js Static Decision Making 12

()

()

CE = g 1 X + 1 + g 2 X + 2 , s ,g s = X , s ,g s ,

()

()

()

()

() ()

() ()

(1.32)

and the risk premium is implicitly determined by the equation

u CE = g 1 u X + 1 + g 1 u X + 1 .

() (

( )) ( ) (

( ))

(1.33)

The risk premium can thus be expressed as

X , s ,g s = X u 1 g 1 u X + 1 + g 1 u X + 1 .

() ()

() (

( )) ( ) (

( ))

(1.34)

From this presentation it is obvious that the size of the risk premium depends on the mean of the game, the stochastic deviations of the payoffs from the mean, and the probabilities of these stochastic deviations. In the subsequent graph the risk premium is displayed by the green line.
"!"#
!%

"$

!##&

"!%&# "$
!%

!$#&

!%

!$#
%&

!%

!##

Figure 1.6: Markowitz risk premium

The graphic representation shows that the height of the risk premium depends on four factors:
-

The concavity of the utility function The location of the expected value The stochastic deviations of the payoffs from the mean The probabilities of the stochastic payoffs

Of course we can determine the risk premium in the numerical example. It is determined by the equation

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13

3 4 * 100 + 1 4 * 10000 = 3 4 * 100 + 1 4 * 10000 ,

()

or
2575 = 32.5 .

()

If we square the equation, and solve for the risk premium we receive

= 2575 1056.25 = 1518.75 .

The size of the risk premium is due to the strong concavity of the root-function, the big stochastic deviations from the mean, and the high probability of the low payoff in state 1. 1.5.2 A local approximation of the Markowitz risk premium Kenneth Arrow and John W. Pratt developed a useful and simple measure of this risk premium. The measure can be derived by a Taylor approximation of () from the equation
u X X , = E u X + .

()

(1.31a)

We expand the left side in order to receive

u X X , u X X , u X .

( ) (

) ( )

(1.35)

Expanding the right hand side around E = 0 gives

1 E u X + E u X + u X + 2u X 2

()

( )

( )

( )

1 = u X + E u X + Var u X 2

( )

() ( )

() ( ) ()

(1.36)

1 = u X + Var u X 2

( )

() ( ) ( )

The second order term is necessary since the middle term vanishes because of E = 0 .

If we insert (1.35) and (1.36) into (1.31a), and solve for X , we receive the so-called
Arrow-Pratt approximation of the risk premium:

X , =

u X 1 1 Var = ARA Var . 2 u X 2

( ) ( )

()

()

(1.37)

Of course it is only a local measure of the risk premium around X . From this Arrow-Pratt approximation we acknowledge the central determinants of a risk premium: The level of wealth The (absolute) risk aversion of the individual The volatility of the lottery (game)
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The Markowitz risk premium of the CRRA utility function The risk premium of the CRRA utility function is:
X , =

1 Var X 2

()

(1.38)

1.6 Mean Variance Criterion Many financial models are based on the assumption that the future values of assets are lognormal and/or their returns are normal distributed. In these cases the von Neumann Morgenstern utility function can be redefined on the mean and the variance of a lottery. 1.6.1 Return and Risk of Assets
As the rate of return of an asset is defined as rX = X X 1 the (expected) return r equals
X E X r E 1 = 1= X 1, X X X

( )

(1.39)

and the variance denoted as rr is

2 X 2 X 1 1 1 rr = E 1 E 1 = 2 E X E X = 2 Var X 2 XX , X X X X X

( )

( )

(1.40)

where XX is the variance of the value of the asset. 1.6.2 The EUH in terms of the Rate of Return For some applications it is useful to define the utility over the rate of return rather than the wealth. If we denominate the utility of the rate or return as u ( r ) and the probability function

of the normal distributed rate of return as f ( r ; r , rr ) with the return r and the variance rr (or the standard deviation r ) the expected utility of the rate of return can be expressed as

E u r =

( ) u ( r ) f ( r ; , ) dr .
r rr

(1.41)

It is useful to use the standard normal distributed random variable as

= r r

(1.42)

The expected value of is zero and the variance is equal to one:

r r E r r = E = =0 r r

()

(1.43)

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15

2 r r E r r r r = = E E rr r r =0

{(

) }
2

=1

(1.44)

Having in mind the relation r = r + r we can write dr = r d , and taking into account
f r ; r , rr =

f ;0,1

),

(1.45)

we can rewrite the expected utility of the rate of return in terms of the standard normal variable :
E u r =

( ) u(

+ r

f ;0,1

) d =
r

u(

+ r f ;0,1 d

) (

(1.46)

1.6.3 Indifference curves of a Risk-Averse Investor In order to calculate the - indifference curves it is recommended to understand the expected rate of return as an implicit function of the variance of the rate of return. Therefore, we derive the expected utility with respect to the standard deviation to receive
dE u r = u + d r + f ;0,1 d = 0 . r r d d r r

()

(1.47)

It is convenient to decompose the right hand side of the double equation as

d r d r
!

u f ;0,1 d + u f ;0,1 d = 0 .

() (

() (

(1.48)

"$ "#

Figure 1.7: Mean-Variance Preferences

If we denote positive values of as + and negative values as the concavity of the utility
function implies for + =
Financial Modeling I, js Static Decision Making 16

u 1+ f 1 ;0,1 < u 1 f 1 ;0,1 .

()

()

(1.49)

From (1.48) we derive the slope of the indifference curve as

d r d r
d E U =0

=
( )

u (

+ r f ;0,1 d
r

) ( ) (

u (

+ r f ;0,1 d

A >0. B

(1.50)

(1.49) implies A < 0 . The denominator B is positive since each element of the integrand is positive. Thus, the slope of the indifference curve is positive. The slope of a - indifference curve is increasing iff (if and only if) the individual is risk averse. This can be seen if we derive (1.50) with respect to R . Applying the fraction rule we receive
d d B u r + f ;0,1 d A u r + f ;0,1 d d r d r d r = >0. d r2 B2
2

()

()

(1.51)

Equation (1.51) can be rewritten as

d 2 r
2 r

d 1 A d r A = u r + 2 f ;0,1 d . B d r B B d d r

()

(1.52)

Using equation (1.50) we can express (1.52) as

d 2 r
2 r

1 A AA A = u + 2 + f ;0,1 d . BB B B d B

()

(1.53)

Applying the binomial formula we can simplify (1.53) to

d 2 r 1 A = u f ;0,1 d > 0 . 2 B B d r

()

(1.54)

<0

<0

Thus, the slope of an indifference curves is positive and increasing. Example of a corresponding utility function A simple example of a utility function defined on the return und the risk of an asset can be given as

u r ,r , rr = r rr 2 ,
with r rr = 2 rr > 0 , and 2 r rr = 2 > 0 .
2

(1.45)

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17