The Theory of Investor Choice Under Uncertainty:

Utility
Hakon Tretvoll
Oce: B4 - 099
Email: hakon.tretvoll@bi.no
(Please put GRA 6543 at the start of the subject)
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Learning Objectives:

Question: Given a future outcome is uncertain how do we make

choices?

To model choice, we need . . .

a ranking of outcomes as better or worse

a representation of the ranking that we can work with mathematically

a way to deal with uncertain outcomes

a criteria that determines an optimal decision

We Want to Understand:
1. What is expected utility: Intuition and formal denition
2. The concept of risk aversion
3. Deriving risk premiums
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Introduction

The starting point for modelling choice is preferences

Preferences over elements in a choice set

Jobs: lawyer, accountant, cab driver, . . .

Electronics: smart-tv, iPad, headphones, . . .

Gambles or Risks: buy insurance, live with risk . . .

Aim is to represent preferences with a utility function: preferences

over wealth or consumption

We begin by introducing some notation (see notes)

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Axioms of Cardinal Utility
Assumptions for consistent and rational behaviour under uncertainty:

Axiom 1: COMPARABILITY
x y, or y x, or x y

Axiom 2: TRANSITIVITY
If x y, and y z, then x z

Axiom 3: STRONG INDEPENDENCE

If x y, then G(x, z; ) G(y, z; )

Axiom 4: MEASURABILITY
If x y z, then there exists a unique
such that y G(x, z; )
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Axioms of Cardinal Utility

Axiom 5: RANKING
Assume x y z and x u z. There exist
1
and
2
such that y G(x, z;
1
) and u G(x, z;
2
).
If
1
>
2
, then y u

Additional Assumption
More is preferred to less MU(W) > 0

From these assumptions we can ask:

1. How can we rank various combinations of risk alternatives
2. b) How do we establish a Utility function that assigns a unit measure
to various alternatives such that:
if U(x) = 10 and U(y) = 5 then x y?
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Developing a Utility Function
A Utility function should have two properties:
1. Order preserving: if U(x) > U(y) then x y
2. Expected utility can be used to rank combinations of risky alternatives
U (G(x, y; )) = U(x) + (1 )U(y)
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Developing a Utility Function (2)
1. Order preserving

Consider a set of risky outcomes S bounded by a and b

Consider intermediate outcomes x and y s.t.

a x b and a y b

Axiom 4 there exist unique probabilities s.t.

x G(a, b; (x)) and y G(a, b; (y))

Axiom 5 interpret (x) and (y) as numerical utilities that rank x

and y

Ranking:

if (x) > (y), then x y

if (x) = (y), then x y

if (x) < (y), then x y

Hence, we obtain an order preserving utility function.

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Developing a Utility Function (3)
2. Expected utility

The axioms E(U) can rank combinations of risky alternatives

U (G(x, y; )) = U(x) + (1 )U(y)
(A proof of this starts on pg. 48 of CWS)

In general:
E[U(W)] =

i
p
i
U(w
i
)
Investors seek to maximize E[U(W)]

They make choices by:

1. Calculate E[U] of all outcomes
2. Choose the one that maximizes E[U(W)]
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Mathematical aside: Expectations

Uncertainty is characterised by a probability distribution

This can either be discrete or continuous

The expectation is a measure of the location of a probability

distribution

Discrete: E[ x] =

N
i =1
p
i
x
i

Continuous: E[ x] =

xp( x)d x

Properties: for a random variable

X and a constant a
(1) E[

X + a] =
N

i =1
p
i
(

X
i
+ a) = E[

X] + a
(2) E[a

X] =
N

i =1
p
i
(a

X
i
) = aE[

X]
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Uncertainty and Risk
Denition
The actuarial value of a gamble is its expected outcome.
Denition
A fair gamble (or fair lottery/bet) has an expected outcome of zero.
Denition
A risk averse investor will not accept a fair gamble.
Examples:
1. Coin toss: gain $1 if heads, lose -$1 if tails
2. Gamble x: gain $16 if heads, gain $4 if tails
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Uncertainty and Risk (2)

The simple coin toss is a fair gamble

The expected wealth after gamble x is

E[W] = p
h
W
h
+ (1 p
h
)W
t
= 0.5 16 + 0.5 4 = $10

So if the cost of x is c = $10, it is a fair gamble

E[x] = E[W] c = 0

Consider gamble x: investor has $10 and gains or loses $6 with equal
probability (a fair gamble)
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Uncertainty and Risk (3)

Question: How much would you pay for gamble x? Depends on

attitude to risk
1. Investor willing to pay amount > $0: is risk loving
2. Investor who accepts the gamble at $0: is risk neutral
3. Investor who only wants to pay amount < $0 (requires compensation):
is risk averse, dislikes risky outcomes and prefers the certain amount

We are most interested in risk averse investors

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Uncertainty and Risk (4)

The rst derivative of the utility function is always positive

(we assume investors prefer more to less)
U

(W) > 0 where U

(W) = U(W)/W

The second derivative determines the attitude to risk

For a RA investor the second derivative is negative: U

(W) < 0
Proof.
The utility from not gambling and keeping your $10 U(10).
This must be greater than the expected utility from the gamble:
U(10) > 0.5 U(16) + 0.5 U(4) or:
U(10) U(4) > U(16) U(10)

This gives us a concave utility function

Example: U(W) = W
1
2
(Figure 1)
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Uncertainty and Risk (5)

We can also prove the concavity in reverse: Concavity implies you will
not accept a fair game

If z is a random variable and U(z) is concave then from Jensens

inequality:

The concave transformation of a mean is greater than or

equal to the mean after concave transformation
E[U(z)] < U (E[z])
E[U(W)] = 0.5 U(W
h
) + 0.5 U(W
t
) = 0.5 16
1
2
+ 0.5 4
1
2
= 3
U(E[W]) = 10
1
2
= 3.16
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Risk Premium

How do we convert risk aversion into a monetary value?

Consider gamble x when you have wealth $10. You have to take it, or
pay to avoid it.

Which amount would you pay to avoid the gamble? Markowitz

Risk Premium

If = $0.75 would you pay? If you did:

U = (10 0.75)
1
2
= 3.04
so, yes since 3.04 > 3

What is the maximum amount you would pay?

Solve for by equating certain utility from lower wealth to expected

utility: U(W
0
) = E[U(W
0
)] = 3

= 1 is the Markowitz risk premium (Figure 2)

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Measure of Risk Aversion

A fair bet of plus or minus $x = 6 (16-10, 4-10) gives expected utility

at point A.

If wealth is reduced to W
0
, then the level of utility is U(W
0
)

The risk premium is therefore dened as:

U(W
0
) = E[U(W
0
+ x)]
where W
0
is inital wealth. From this we can obtain the Pratt-Arrow
measure of risk aversion

The risk premium is related to the curvature of the utility

function, lets see how
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Mathematical aside: Taylor series approximation

Say we have a function f (x)

Want: a simpler expression that is an approximation to f (x)

Taylor: approximate around a point x by using knowledge of the

function and its derivatives at x
f (x) = f ( x + x x) f ( x) + f

( x)(x x) +
f

( x)
2
(x x)
2
+. . .

Figure 3

Common to use either rst-order or second-order approximations

Accuracy depends on order of approximation and distance x x

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Measure of Risk Aversion (2)

U(W
0
) = E[U(W
0
+ x)]: Take a Taylor series approximation of
both sides around the points x = 0 and = 0. Assume higher order
terms are insignicant

LHS:
U(W
0
) U(W
0
) + U

(W
0
) ()
(ignore higher order terms)

RHS:
E[U(W
0
+ x)] E

U(W
0
) + U

(W
0
) x +
U

(W
0
)
2
x
2

Note: E[U(W
0
)] = U(W
0
) this is known and non-random

E[x] = 0 by assumption (actuarilly neutral)

E(x
2
) =
2
x
because
2
x
E[(x) E(x)]
2
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Measure of Risk Aversion (3)

Thus, RHS becomes:

E[U(W
0
+ x)] U(W
0
) +

2
x
2
U

(W
0
)

Equate LHS = RHS:

U(W
0
) + U

(W
0
) () = U(W
0
) +

2
x
2
U

(W
0
)

Solve for :
=

2
x
2

(W
0
)
U

(W
0
)

Since

2
x
2
> 0, the sign of the RP is determined by the term
U

(W
0
)
U

(W
0
)

For a risk averse investor: U

(W
0
) > 0 and U

(W
0
) < 0
the RP is always positive
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Measure of Risk Aversion (4)

Note: the amount you are willing to pay to avoid a fair bet depends
on:
1. riskiness of outcome,
2
x
2. shape of utility function U

(W
0
) and U

(W
0
)
3. initial wealth W
0

You may be very risk averse -U

(W
0
) is very large, but unwilling to
pay a high premium if you are very poor (U

(W
0
) will also be high).

We consider two measures of the degree of RA:

1. Absolute risk aversion (ARA) - measures RA towards a change in
wealth by a certain amount: ARA=
U

(W)
U

(W)
2. Relative risk aversion (RRA) - measures RA towards a change in wealth
by a certain fraction: RRA =
U

(W)
U

(W)
W
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Exercise: Relative risk aversion

Derive the expression for RRA. Starting point: what fraction of

wealth would an investor give up to avoid a fair gamble that would
change wealth by a fraction determined by a random variable x?
U(W
0
(1 )) = E[U(W
0
(1 + x))]

Answer: on Its Learning

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Examples of Utility Functions

A risk lover will have a convex utility function over wealth:

U(W) = W
2

A risk neutral investor will have a linear utility function:

U(W) = b W with b > 0

A risk averse investor will have a concave utility function over wealth
(see next slide...)

So we have (Figure 4): U

(W) < 0 RA; U

(W) > 0 RL; U

(W) = 0
RN
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Examples of Utility Functions (2)
Examples (and conditions that must hold for risk averse investor)

Quadratic utility: U(x) = a + b x + c x

2
(require c < 0 and restriction on x)

Logarithmic utility: U(x) = b ln x

(require b > 0)

Exponential utility: U(x) = b exp(c x)

(require b < 0 and c < 0)
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Comparing RA for Small and Large Risks

Pratt-Arrow RA assumes risks are small and actuarially neutral,

Markowitz doesnt.

Example (CWS):

U = ln(W), W = $20000

Two risks:
1. 50-50 chance of gaining/losing $10;
2. 80% chance of losing $1000, 20% chance of losing $10,000.

Whats the risk premium required for these two risks?

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Comparing RA for Small and Large Risks (2)

First risk is small and actuarially neutral: Pratt-Arrow measure

=

2
x
2

(W)
U

(W)

Variance:

2
x
=

i
p
i
(X
i
E(X
i
))
2
= 0.5(20010 20000)
2
+
0.5(19990 20000)
2
= 100

(W) = 1/W, U

(W) = 1/W
2

Thus
U

(W)
U

(W)
=
1
W
=
1
20000

Thus
=
100
2

1
20000

= 0.0025
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Comparing RA for Small and Large Risks (3)

Markowitz Measure - compute the expected utility of the gamble

E[U(W)] =

p
i
U(W
i
)
= 0.5 U(20010) + 0.5 U(19990)
= 9.903487

Which W gives this utility?

CEW = exp(ln(CEW)) = 19, 999.9974998

MRP = E[W] CEW = 0.0025002

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Comparing RA for Small and Large Risks (4)
Second Risk: Pratt-Arrow
=

2
x
2

(W)
U

(W)

2
x
=

i
p
i
(X
i
E(X
i
))
2
= 0.8(19000 17200)
2
+
0.2(10000 17200)
2
= 12, 960, 000
=
12, 960, 000
2

1
20000

= 324
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Comparing RA for Small and Large Risks (5)

Markowitz Measure - compute the expected utility of the gamble

E[U(W)] =

p
i
U(W
i
)
= 0.8 U(19000) + 0.2 U(10000)
= 9.7238

Which W gives this utility?

CEW = exp(ln(CEW)) = 16, 710.62

MRP = E[W] CEW = 489.4

$489.4 > $324

MRP is better for large asymmetric risks.

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Summary
1. Expected utility is a means of making choices regarding risky
outcomes.
2. We will focus on risk averse investors
3. Conave utility functions
4. We can estimate risk premium and then make choices

Reading: CWS chp 3A-3D (also 3H)

Exercises:
1. Work through the proof that expected utility can be use to rank risky
alternatives (pg. 48, CWS)
2. 3.3, 3.4, 3.5, 3.8, 3.9
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