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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
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

  • 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