Last Day. Utility Analysis. Today. Utility Analysis (cont’d) International Diversification. Expected Utility Theory:. The nice thing about this theory is that it is consistent with choice that would be made by examining the investment directly
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Utility Analysis (cont’d)
The above example has an expected value of 1 if the individual decides to invest.
Now assume that to invest, the individual would have to pay $1. If she/he chooses not to invest, then the dollar is kept (hence, the do not invest payoff)
The point of all of this?
The expected value of making the gamble is exactly offset by the cost
So, a change in utility from a one unit change in wealth is independent of the relative magnitude; that is a change from 0 to 1, is the same as a change from 1 to 2.
Taking the derivative of this equation would show how an investor’s absolute risk aversion varies as we change wealth.
Where a and b are constants, what are the signs of a and b, assuming the investor prefers more to less and is risk averse.
Portfolio Diversification in a World Context
Risk and Returns of Foreign Securities
What is the return to a German Investor? What about the U.S. investor?