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# Chapter 13 - 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.

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## PowerPoint Slideshow about 'Chapter 13' - jamar

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Presentation Transcript

• Risk Attitudes

• Learning Objectives:

• Utility Function

• Utility Function Assessment

• Exponential utility Function

• 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.

• 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.

• 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 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

• 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.

• 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

• 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.

• 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

• 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.

• 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.

• 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

• Summary

• Basic concepts that underlie risk and return trade-offs

• Basic procedure for assessing utility function

• Certainty Equivalents and Risk Premium