Chapter 13

1 / 15

# Risk Attitudes - PowerPoint PPT Presentation

Chapter 13. Risk Attitudes. Chapter 13, Risk Attitudes. Learning Objectives: Utility Function Risk Premium Utility Function Assessment Exponential utility Function. Risk Attitudes. This chapter will discuss the problems associated with risk and return trade-off.

I am the owner, or an agent authorized to act on behalf of the owner, of the copyrighted work described.

## PowerPoint Slideshow about 'Risk Attitudes' - jamar

Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author.While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server.

- - - - - - - - - - - - - - - - - - - - - - - - - - E N D - - - - - - - - - - - - - - - - - - - - - - - - - -
Presentation Transcript
Chapter 13
• Risk Attitudes
Chapter 13, Risk Attitudes
• Learning Objectives:
• Utility Function
• Utility Function Assessment
• Exponential utility Function
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
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.
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.
Risk Attitude
• Utility Function is only a model of an individual’s attitude toward risk.
• Three different shapes for utility functions:
• Risk-Seeking
• Risk-Neutral
• Risk-Avers
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
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.
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 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.
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
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.
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.
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
Risk Attitudes
• Summary
• Basic concepts that underlie risk and return trade-offs
• Basic procedure for assessing utility function
• Certainty Equivalents and Risk Premium