Chapter 13

Risk Attitudes

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 Chapter 13, Risk Attitudes
Learning Objectives:

Utility Function
Risk Premium
Utility Function Assessment
Exponential utility Function

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 Risk Attitudes
This chapter will discuss the problems
associated with risk and return trade-off.
Study of preference for decision making
It is important for decision maker to
consider their attitudes toward risk

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 Risk
Basic decision on expected monetary values
(EMVs) is convenient, but it can lead to
decision that may not seem intuitively
appealing.
Using expected Values to make decision
means that the decision maker is
considering only the average payoff
EMV does not capture the risk attitudes.
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 Utility Function
The utility Function represents a way to
translate dollars into Utility Units.
A utility function might be specified in
terms of :
Graph
Tabular form
Mathematical expression.

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 Risk Attitude
Utility Function is only a model of an
individuals attitude toward risk.
Three different shapes for utility functions:
Risk-Seeking
Risk-Neutral
Risk-Avers

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 Risk Attitude

Risk neutrality is reflected by a utility curve that

is simply a straight line.
For Risk Neutral person , maximizing EMV is the
same as maximizing expected utility
A convex (opening upward) utility curve indicates
risk-seeking behavior
A concave (opening downward) utility curve
indicates risk-averse behavior

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 Risk Attitude
The purpose of a utility function is to help
decision maker to choose from among
alternatives that have uncertain payoffs.
Instead of maximizing expected value, the
decision maker should maximize expected
utility.

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 Risk Attitudes
Expected Utility
Using Expected Utility to rank alternatives
in order of preference
Two concepts are closely linked to the idea
of expected utility:
Certainty Equivalent
Risk Premium

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 Risk Attitudes
Certainty Equivalent: the amount of money
that is equivalent in your mind to given
situation that involves uncertainty.
Ranking alternatives by their certainty
equivalents is the same as ranking them by
their expected utilities.

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 Risk Attitude
The notation of a Risk Premium can be
thought of as a measure of how risk-averse
a decision maker is in regard to a particular
risky situation.
The risk premium is defined as the
difference between the EMV and the
certainty equivalent.
Risk Premium=EMV - Certainty Equivalent
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 Risk Attitudes
Certainty equivalent is a dollar amount,
whereas expected utility is in utility units
A certainty equivalent is not the same as the
expected utility
The two measurements translate through the
utility function.

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 Utility Function Assessment
The basic procedure for assessing a utility
function requires comparison of lotteries
with riskless payoffs
Different people have different risk attitudes
and thus are willing to accept different level
of risk.
Assessing a utility function is a matter of
subjective judgment, just like assessing
subjective probability. 13
 Utility Function Assessment
Two utility-Assessment approaches:
Assessment using Certainty Equivalents
Requires the decision maker to assess several certainty
equivalents
Assessment using Probabilities
This approach use the probability-equivalent (PE) for
assessment technique
Exponential Utility Function:
U(x) = 1-e-x/R
R is called risk tolerance
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 Risk Attitudes
Summary
Basic concepts that underlie risk and return
trade-offs
Basic procedure for assessing utility
function
Certainty Equivalents and Risk Premium

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