Utility and Risk

Aversion

Summary

Rational Decision: St. Petersbourg paradox

Utility and Expected Utility of Wealth

Risk Aversion, Risk Neutrality, Risk Loving

Risk premium, Insurance premium, Certainty

Equivalent

Arrow-Pratt (approximate) risk premium

St. Petersburg Paradox

Suppose someone tosses a coin

repeatedly. You receive $1 if head comes
up on the first toss, $2 if head comes up
for the first time on the second toss, 4$
if head comes up for the first time on the
third toss and so on

St. Petersburg Paradox

heads

tail

1
2
1
2

$20

1
2
1
2

1
2

21
1
2
1
2

22

1
2
1
2

2n-1

St. Petersburg Paradox

heads
tail

1
2

1
2

$20
1
2
1
2

1
2

21
1
2

1
2

22
1
2

2n-1

1
2

1
1
1
n 1 1
E (W ) 1 2 4 2
2
4
8
2
1
1
1
1
1

n
2
2
2
2
2

St. Petersbourg Paradox

- conclusion People should pay an infinite amount of
money for the right to play this game as
n increases without limit.
However, this does not describe the
human behavior.
So, expected wealth is an
insufficient measure for the value of
a gamble.

Rational Investors

- Expected Utility Representation -

Rational = investors are endowed with

preferences over random consumption plans.
A consumption plan looks like a lottery over the
future possible states of nature:
x1

q1

y1

p1

~
x

p2
p3

p4

x2
x3
x4

~
y

q2

y2
q3

y3

Rational Investors

- Expected Utility Representation Preferences have expected utility representation if

there exists a function U such that

~
x~
y EU ~
x EU ~
y
preferred to

p(1 )

~
x

x(1 )

EU ~
x U x prob

1 , 2 , 3 , 4

p(2 ) x(2 )

p(3 ) x(3 )
p(4 )

x(4 )

EU ~
x p1U [ x(1 )] p2U [ x(2 )] p3U [ x(3 )] p4U [ x(4 )]

Rational Investors

- Expected Utility Representation Investors are rational if they

Can compare gambles

Can make consistent comparisons:

~
~
xy
~
~
yz

~
~
xz

Problems with the expected utility rule Allais paradox

Risk aversion
Definition:

An individual is risk averse if he is unwilling to

accept any actuarially fair gamble (a gamble for
which the expected value is 0).

Result:

Risk aversion = Utility function is concave

Proof of Risk Aversion:

St. Petersburg paradox diminishing marginal

utility
If risk averse (no actuarially fair gamble) then U
is concave (diminishing marginal utility)

U is concave - proof
For any w1 and w2 with w1< w2 and p a
~
probability, let h be the gamble

ph1 (1 p)h2 0

Suppose the initial wealth is

W0 pW1 (1 p)W2

Then, a risk averse investor will refuse

the actuarially fair gamble, i.e.

~
U W0 E U W0 h p U W0 h1 (1 p)U W0 h2

The concavity of the utility

function
U pW1 1 p W2 pU W1 1 p U W2

~
~
U EW EU W
~
~
U EW EU W

Certainty
Equivalent

Risk aversion

Money in your pockets

worth more than
expected money in
your pockets

Utility of Average if we
have it certainly
U[E(W)]

Utility

U(W2)
Risk Aversion

Average
Utility
E[U(W)]

U(W1)

Expected Wealth
(average)
E(W)
0

W1

W2

Wealth

A way to measure Risk

Aversion
Risk aversion:

~
~
U EW EU W

Since U>0, there exists a

such that:

Risk premium

~
~
U E W E U W

~
~
1
Certainty equivalent wealth: E W U E U W

~
E W

The value of the risk premium

~
~
~
~
~
~
~
U E W U E W U ' E W E W E W U E W U ' E W

1
~
~
~ ~
~
~ ~
~

E U W E U E W U ' E W W E W U ' ' E W W E W

2

1 2 U ' ' W0

2 U ' W0

Utility of Average if we
have it certainly
U[E(W)]

Utility

U(W2)

Risk Aversion

Average
Utility
E[U(W)]

U(W1)

Expected Wealth
(average)
E(W)
0

W1

W2

Wealth

Finding an approximation for

the risk aversion
It is merely an approximation; it works
only for small risk all the moments of
wealth of order greater than 2 are negligible
with respect to the variance

~
1 2 U '' W

~
2 U' W
Arrow-Pratt measure of Absolute
Risk Aversion (ARA)