Risk averse vs.

risk neutral investors and the security valuation under uncertainty

2012 02 22

Yinghong.chen@liu.se

 Risk averse investors prefer a sure thing C (in money terms) instead of an uncertain outcome that has an expected payoff equals to C, with probability p of having a high payoff H and with probability q of having a low payoff L. E(H, L, P, q)= pH+qL=C Risk averse investors have a low threshold of risk tolerance, they prefer to invest in fixed income instrument, with a low volatility in return. The risk aversion is represented by a concave utility function U, U>0, U<0. e.g. U= Ln(C ), U=

Risk averse investors

Certainty equivalent
When facing uncertain outcome, they would value the uncertain payoff (H, L) lower than its fair market value C. To induce risk averse investors hold risky assets, the pricing of the risk assets has to be lower than E(H, L, p, q), We use certainty equivalent CE to denote the value the risk averse investor is willing to pay. i.e. CE<C.

Risk neutral
Simple example: Suppose there is a lottery ticket that pays 4 with probability p = 1/2 and 16 with probability (1 p) = 1/2. What is the ticket worth?

The answer is C= 0,5 * 4 + 0,5*16 = 10

Risk Neutral
A person indifferent to risk is said to be risk neutral. E [U(C)]= U (E[C]) Risk neutrality = linear utility A risk averse individual has E [U(C)] < U (E[C]) (Jensens inequality ) where U (E*C+) is the utility over a sure thing E(C). E [U(C)] is expected value of the uncertain utility resulting from the two states.

Risk Neutral
A game with risk neutral probability p of achieving H, and 1-p of achieving L. The expected return is Note at the end of the game we are get either the H or the L, which is different to our expected value .
U U(H) E(U(H,L))=U( ) U(L)

Risk averse investor with a utility function U(C)= and certainty equivalent value is CE, where CE<

U(CE)=E(U(H,L,p,q))
U U(H) U( ) E[U] U(L)

CE

E[U]=U(CE), in our example E(U)=

The pricing of securities when investors are risk averse

For risk averse investors, the same lottery with a fair price 10 is valued at a value lower than the fair market value (certainty equivalent: CE). For example, if the investor has an utility function U(C) = The certainty equivalent (CE) of the lottery: U(CE)= =0,5* 4 + 0,5 * 16 =3 CE=9 The risk averse investor would only like to pay 9 for the same lottery. The difference= Expected value Certainty Equivalent

Risk neutral probabilities p*

Now consider someone who is risk-neutral, with the simple linear utility function U(C) = C. What probabilities would make him willing to pay exactly 9 for the game? Note that, for this person A. U(9) = 9 B. E[U(H, L, p, 1-p)+=p*4+(1-p*)16=9 p*=7/12 Risk-neutral probabilities are the probabilities that is consistent with observed prices given the investor is risk neutral.