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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.

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Presentation Transcript
chapter 13
Chapter 13
  • Risk Attitudes
chapter 13 risk attitudes
Chapter 13, Risk Attitudes
  • Learning Objectives:
  • Utility Function
  • Risk Premium
  • Utility Function Assessment
  • Exponential utility Function
risk attitudes
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
  • 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
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
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 attitude1
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 attitude2
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 attitudes1
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
risk attitudes2
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 attitude3
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 attitudes3
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
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 assessment1
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 attitudes4
Risk Attitudes
  • Summary
  • Basic concepts that underlie risk and return trade-offs
  • Basic procedure for assessing utility function
  • Certainty Equivalents and Risk Premium