1.

Define the relationship between stochastic dominance of second order (SOSD) and risk
aversion
Second order stochastic dominance: at this point we need to introduce a comparison based on
relative riskiness (or dispersion). In particular we will consider distributions with the same mean
but different dispersion. Given two distribution with the same mean F(*) and G(*), so

( )=
( ), we say that G(*) is riskier than F(*) if every risk averter prefers F(*) to G(*).
Formally, for any two distribution F(x) and G(x) with the same mean, F(*) second order
stochastically dominate or is less riskier than G(*) if for any non decreasing concave function
we have: ( ) ( ) ( ) ( )
3.Define a fair insurance.
If the insurance is actually fair the decision maker is insured completely. Let us consider w is the
initial wealth; D is the potential loss; is the probability of loss; q is the cost of insurance and are
the unit of insurance bought. Thus the level of wealth if the loss will occur is equal to + ,
while if the loss won't occur the level of wealth is . We want to maximize our expected
utility so we have to chose the optimal level of a. An insurance is fair when q = .
4. What is the relation between probability and Lebesgue measure?
Lebesgue measure is frequent used in problems of the probability
theory, in physics and other domains. It is suciently to recall that in the
probability theory, a Borel measurable application is also a random variable
dened on a selection space.
The Lebesgue measure (L) is of great importance in applications on R
N and we know that is invariant with respect to all the travels
5.

A risk measure is coherent if

Let be a measure of risk ( is the state space) . p is a current risk measure if it satisfies
the following axioms:
1. Transitional invariance: and , then ( + )= ( ) ;
2. Subadditivity: 1, 2 then ( 1+ 2) ( 1)+ ( 2);
3. Monotonicity: 1, 2 then 1 2

( 1) ( 2);

4. Positive homogeneity: and , then (

)= ( )

Z is a lottery or a portfolio.

2. What is the main consequence of Ellsberg Paradox?

Is a paradox in which people choice violates the postulate of subjective expected utiliy. The
idea is that people prefer taking on risk in situation where they know specific probabilities
than alternative risk scenario in which the probability are completely ambiguous. Ellen

makes an experiment with an urn and result are opposite and it evidence he violation of
Sure_ thing principle that are incosinstent with hypothesi of Expected Utility maximation.

3. Is Expected Utility Theory a normative and descriptive theory? Explain in a simple

way
Expected Utility Theory Is a normative theory because it may provide a valuable guide to
action to deal with the risk alternative.
5. What are the main characteristics of a Constant Absolute Risk Aversion utility function?
Discuss and show an example+
Increasing ARA: as wealth increases the amount of money held in risk asset decrease (more risk
averse);
Decreasing ARA: as wealth increases the amount of money held in risk asset remain the same
(more risk neutral);
Constant ARA: Is that as wealth increases the amount of money held in risk assets
increases.(more risk lover)
The Arrow-Pratt coefficients of absolute risk aversion: given a twice differenciable Bernoulli utility
function u(*) formally Arrow-Pratt coefficients of absolute risk aversion of x is defined:
( )= ( ) ( )
3. Comparative risk evaluation: stochastic dominance and mean variance approach.
the Markowitz model, where decision makers are assumed to have quadratic utility functions with
negative second derivatives has been widely criticized because of risk preference implied and
normality of date required. Additionally the quadratic utility function implies that beyond some
wealth level the investor's marginal utility becomes negative. In contrast, stochastic dominance,
can be used as an alternative method to examine portfolio construction and rankings. The
stochastic dominance use the entire probability density function rather than a finite numbers of
moments, so it is less restrictive. There are no assumption made concerning the form of the
returns distributions and not much information on investors preference are needed to rank
alternatives. Higher order stochastic dominance have increasingly stringent conditions to meet but
have higher power of discrimination.

4. Explain portfolio diversification between risky and safe assets.

We have two asset: one is safe and it yields a return of 1 per euro invested, the risky one yield a
random return of z per euro invested. z has the distribution function F(z) that satisfies
( )>1,
this means that its average return exceed the return of the safe asset. W is the initial wealth to
invest that can be divided among the asset; is the amount invested in the risky asset and the
amount invested in the safe asset; the portfolio (,) pays z + and + = w. now the utility
maximisation problem is:
( + ) ( )
+ =
If * is optimal it has to satisfy the Kunn Tucker first order condition:
( )= [ + ( 1)]( 1) ( ){ 0
< 0
>0
>0 means that there aren't short selling. Note that
( )>1 implies (0)>0, so if =0 cannot
satisfy the first order condition. So the optimal portfolio has >0. We conclude that if a risk is
actuarially favourable, than a risk averse will always accept a least a small amount of it.

4. If F(.) Second Order Stochastically Dominates G(.), than G(.) is a mean preserving spread
of F(.): explain and show (technically).
we have two lotteries over x. The first one is distributed according to F(*). In the second one we
randomize each outcome x, so the final payoff would be x + z where z has a distribution function
( ) with mean
=0. So the mean of x + z is x. The resulting lottery is distributed according
G(*). When lottery G(*) can be obtained from F(*) in this manner from some distribution H(*) then
G(*) is a mean preserving spread of F(*). So with G(*) mean remain the same but dispersion
change. G(*) is more dispersed so is riskier. Consequently F(*) second order stochastic dominate
G(*).
So if we know that the mean of G(*) is equal to the mean of F(*) and if u(*) is concave we can
write that: ( ) ( )=( ( + )
( )) ( ) (( + )
( )) ( )= ( ) ( )
5 Continuity and Allais Paradox
We have at least three possible monetary outcomes (as show in the table). The decision maker is
subject to two choice test: the first consist of a choice between L1 and L1' and the second one
consist of a choice between L2 and L2'. Several studies prove that people choose L1 between L1
and L1' and they chose L2' between L2 and L2'. However those choices are not consistent with
expected utility. The allais paradox violates the continuity axiom because small changes in
probabilities do not change the nature of the ordering between two lotteries but in allais paradox
we change the nature of the ordering.
2. What is the probability premium?
given a fixed amount of money x and a positive number , the probability premium denoted by
( , , ) is the excess in winning probability over fair odds that make the individual indifferent
between the certain outcome x and a gamble between x + and x - . ( )=[12+ ( , , )
] ( + )+[12 ( , , ) ] ( )

3. What is a probability?

Classical Approach: equal probabilities are assigned to all outcomes (n possible outcomes and
there is no reason to view one more likely than another one, so each event has probability equal
to 1/n).
Frequentist Approach: probability of an event is the relative frequency observed in the past ( if an
event occur x times over a sample of observation equal to n, the event has probability x/n).
Subjective Approach: One way to deal with probability is to treat them as purely subjective.
According to this approach, saying that the probability of event A is p, reflects one persons beliefs
about it.
1. Define and give an example of stochastic dominance of first order (FOSD), and explain
when FOSD implies stochastic dominance of second order (SOSD).
When lottery G(*) can be obtained from F(*) in this manner from some distribution H(*) then G(*)
is a mean preserving spread of F(*). So with G(*) mean remain the same but dispersion change.
G(*) is more dispersed so is riskier. Consequently F(*) second order stochastic dominate G(*)
FOSD implies that distribution F(.) yelds unambiguously higher return than the distribution G(.)
while SODS implies that F () second order stochastically dominate is less risker than G(.).
according to the definition of SODS the area between Y and X should always be non negative.
Consequently

====>
. In fact if ( ) ( ) then 0 always. And the integral of this
difference would be positive as well
1. What is the meaning of the continuity axiom on the space of simple lotteries?

Practically continuity means that that small changes in probability do not change the nature of
ordering between two lotteries. The continuity axioms implies the existence of utility function
representing , a function such that if and only if ( ) ( ).
WHY THE ASYMMETRIC INFORMATION INDUCES PARETO INEFFICIENCY
Pareto efficency is a state in which it s possible to make any one individual better off without making at least
one individual worse off. An allocation is pareto optimal when nofurther pareto improvements can be made
there are asymmetric information pareto is inefficient because the asymmetric information leads to a

situation with a missing market and then creates the externalities for instance in the labor market model not
every worker are employed.
WHAT IS THE MEANING OF THE INDEPENDENCE AXIOM IN THE FRAMEWORK OF VAN
NEUMAN EXPECTED UTILITY
The independence axiom states that if we mix each of two lotteries with a third one. The preferences
order of the two resuting mixtures does not depend on the particular third lottery used. The
preference relation >= on the space of the simple lotteries satisfies the independence axioms,

if for any , , and [0,1] if

< = > +(1 ) +(1 )
The indipendence axiom is te heart of the theory of choise under risk.
WHAT IS THE LEMON MARKET AND HOW IS POSSIBLE TO EMEND IT (AKERLOF)

The lemon market, developed by Akerlof, is the market of second hand cars discuss about
asymmetry information which occur when the seller know more information about product than
the buyer. He concudes the example that: owner of good cars will non place their cars on the used
market. To emand this problem the central authority can try to improve the information in the
market.
What is the main difference between Prospect Theory and Cumulative Prospect Theory?
The main difference is that the Cumulative Pros. The. Doesnt violet the FOSD. In fact, the main
problem of the Prospect Theory is the violetion of the FOSD and this is solved applying the rank
dependent utility (RDU) (special case of Choquet Expected Utility Theorem). In this case the
integral is respect to the Capacity.
3. What is a capacity?
When an individual agent does not know all the states of the world and he is unable to attach a
unique probability distribution he will have distorted probabilities that are non-additive. These
probabilities are called capacities. Is asymmetric, and if it is convex choquet integral is convex and
viceversa.
Properties:: a) normalize;b) monotone ,c)non negative;d) super modular; if no sub modular;
e)super additive, if not sub additive. (Super nodular: means is convex if is not concave).
4. What is the Probability Weighting Function?
A typical prospect theory probability weighting function, ( ), is concave for small probabilities
and convex for medium to large probabilities (and thus consistent with the principle of diminishing
sensitivity). The function is a probability weighting function and express that people tend to
over-react to small probability but under-react to medium and large probabilities. Prospect theory
assumes that individuals do not weigh outcomes by their probability, as in expected utility theory,
but by some distortion of probabilities. This distortion of probability is captured by prospect
theorys probability weighting function

2. Allais Paradox violates some axioms, discuss and show in the simplex.
Violates the axiom of continuity and independence.

3. Explain the main difference between expected utility and prospect theory
Expected utility theory assumes that preferences between prospects do not depend on the
manner in which they are described: this compelling principle is known as the invariance
assumption. However, prospect theory demonstrates that the same choices can be framed in
different ways to produce dramatically different preferences. In other words, our choices do not
always obey the invariance assumption.
Prospect theory assumes that individuals do not weigh outcomes by their probability, as in
expected utility theory, but by some distortion of probabilities.
5 . In optimal incentive scheme, compensation is not necessarily monotonically increasing in
profits. Explain and show (formally).
2. Differences and analogies between risk and ambiguity. Give a formal definition of them, at
least.
Risk represents a situation in which information is available in form of probability distribution. The
individual then choose among lotteries (i.e. probability distribution on some outcome space).
Ambiguity Aversion is the attitudes of preferences for known risk over unknown risk. Due to this
ambiguity in probabilities, the agent is not able to evaluating precisely expected utility, so a choice
based on maximising utility is also impossible (the rationality goes away because we have to face
some unknown risk).
3. Capacity and Choquet integral. Give a formal definition and an intuitive idea.
Vedi domanda su capacity
4. What is the meaning of the independence axiom on the space of simple lotteries? Give an
explanation in the simplex.
The preference relation on the space of the simple lotteries satisfies the independence
axioms, if for any , , and [0,1] if
< = > +(1 ) +(1 )
Practically, if we mix two lottery with a third one then the preference order of the two resulting
mixture does not depend on the particular third lottery used.
The independence axiom is the heart of the theory of choice under risk.
5. The optimal contract when the effort is not observable and the agent is risk neutral is.
Give an intuitive and formal representation.
In this case the optimal contract requires exactly the same effort choices and expected utilities than
when the manager effort is non observable because efficient incentives our provided. So the
manager will receive a wage that is equal to that is equal to his reservation utility level and it will be
fixed. The point in which the expected wage is maximized is the tangent point between the
managers indifferent curve and the owners isoprofit curve.
5b. The optimal contract when the effort is not observable and the agent is risk adverse is.
Give an intuitive and formal representation.
in the principal agent model with unobservable manager effort, a risk averse manager, and two
possible efforts choices, the optimal compensation scheme for implementing eH satisfies
condition 1 [ ( )]= + [1 ( | ) ( | )], gives the manager expected utility , and involves a
lager expected wage payment than is required when effort is observable. The optimal
compensation scheme for implementing eL involves the same fixed wage payment as if efforts
were observable. Whenever the optimal effort level with observable effort would be eH,
nonobservability causes a welfare loss.
In this model nonobservability produce only downward distortion in the manager effort level
because we have only two levels efforts. If we take more levels of efforts the bias can be both
upward that downward.

5c. The optimal contract when the effort is osservable and the agent is risk adverse is. Give
an intuitive and formal representation.
in this context the contract specify the effort level and the wage payment is a function of observed
profit w(). is the managers reservation utility level.
in the principal agent model with observable managerial effort, an optimal contract specifies that
the manager choose the effort e* that maximizes ( | ) 1( + ( )) and pays the manager
a fixed wage = 1( + ( )). This is the uniquely optimal contract if the ( )<0 at all w.
PAPER KEYNES
For Keynes the market is not efficient because there are some problems about asymmetric
information and negative externalities. He state that the price of stock is more value. Moreover
the financial professionals, like speculators, wake their job-choises trying to predict the
expectation of the other people; so the stock price is determined by expectation of expectation.
WHAT IS THE ROLE OF ITERATIVE LAW OF EXPECTATION AND WHAT IS ITS UNDERLIND STATICAL
RULE?
The iterative law of expectation holds if and only if a probability measure is additive. This indicates
that a market price of uncertain asset way not reflect the market information about the asset. The
statical underlined once is the Bayesian Statistic it is the tool of decision maker who attempt to
sort out their knowledge ,belief, intuition.
The prisoner's dilemma ?
The prisoner's dilemma is a direct application of nash theory equilibrium and in general is used in
the game theory. This game shows why two "pluraly" rational individuals weight not cooperate
even if it appears that itis in their best interests to do so. The prisoner's dilemma caused interest
as an example of game where the rationality axiom appears to fail, prescribing an action that
demages more the confess of the determinative choice,(doesn't confess, doesn't confess).

Bounded rationality?
It's the idea that in decision making, rationality of individuals is limited by the information they
have and the limit amount of time they have to make a decision. Another way to look at bounded
rationality is that because decision makers look the ability and resources to arrive at the optimal
solution, they apply their rationality only after having gratefully simplified the choices available.

Multiple prior
When you have bounded rationality is a way of evaluating acts.two principle approches:
1 condition of extreme events
2 the convex combination of the core of distribution.

Rank depend utility

Rank-dependent utility: The original version of prospect theory violates the first-order stochastic
dominance. A revised version, called cumulative prospect theory (CPT) overcomes this problem
by using a probability weighting function derived from rank-dependent expected utility theory and
adding a reference point (current wealth = 0). In the CPT, cumulative prospective probabilities are
transformed, rather than the probabilities itself. This modification helps to avoid violation of FOSD.
The rank dependence utility or rank dependence expected utility states that the decision weight
of receiving outcome depends only on its probability and its ranking position. So a
probability vector is defined by:

n.b X INFO PAG 17

Differences and analogies between Rank and Cumulative.

Both take into account the distribution on probability function and are interested into marginal
probabilities.
Both are weighted function .
Rank can be applied under decision of risk .
Cumulative can be applied under decision of risk and under uncertain situations.
Both are represented by capabilities ( choquet integral) instead of probabilities.

Demand of risky asset

Let and denote the amounts of wealth invested in the risky and safe asset, respectively. Thus,
for any realization of the random return, the individuals portfolio ( , ) pays + . Of course,
we must fulfill the condition: + =
The utility maximization problem of the individual is: