Chapter 13
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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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Chapter 13

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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


Risk attitudes 1316589

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


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