Professional Documents
Culture Documents
Uncertainty and Risk Aversion
Uncertainty and Risk Aversion
UNCERTAINTY AND
RISK AVERSION
Probability
The probability of a repetitive event
happening is the relative frequency with
which it will occur
probability of obtaining a head on the fair-flip
of a coin is 0.5
i 1
Expected Value
For a lottery (X) with prizes x1,x2,,xn and
the probabilities of winning 1,2,n, the
expected value of the lottery is
E ( X ) 1x1 2 x 2 ... n x n
n
E ( X ) i xi
i 1
Expected Value
Suppose that Smith and Jones decide to
flip a coin
heads (x1) Jones will pay Smith $1
tails (x2) Smith will pay Jones $1
Expected Value
Games which have an expected value of
zero (or cost their expected values) are
called actuarially fair games
a common observation is that people often
refuse to participate in actuarially fair games
Fair Games
People are generally unwilling to play
fair games
There may be a few exceptions
when very small amounts of money are at
stake
when there is utility derived from the actual
play of the game
we will assume that this is not the case
6
1
E ( X ) i xi 2
2
i 1
i 1
E ( X ) 1 1 1 ... 1
Expected Utility
Individuals do not care directly about the
dollar values of the prizes
they care about the utility that the dollars
provide
Expected Utility
Expected utility can be calculated in the
same manner as expected value
n
E ( X ) iU ( xi )
i 1
12
13
15
18
Risk Aversion
Two lotteries may have the same
expected value but differ in their riskiness
flip a coin for $1 versus $1,000
Risk Aversion
In general, we assume that the marginal
utility of wealth falls as wealth gets larger
a flip of a coin for $1,000 promises a small
gain in utility if you win, but a large loss in
utility if you lose
a flip of a coin for $1 is inconsequential as
the gain in utility from a win is not much
different as the drop in utility from a loss
20
Risk Aversion
Utility (U)
Wealth (W)
21
Risk Aversion
Utility (U)
U(W*)
W*
Wealth (W)
22
Risk Aversion
Suppose that the person is offered two
fair gambles:
a 50-50 chance of winning or losing $h
Uh(W*) = U(W* + h) + U(W* - h)
a 50-50 chance of winning or losing $2h
U2h(W*) = U(W* + 2h) + U(W* - 2h)
23
Risk Aversion
Utility (U)
U(W)
U(W*)
Uh(W*)
W* - h
W*
W* + h
Wealth (W)
24
Risk Aversion
Utility (U)
U(W)
U(W*)
U2h(W*)
W* - 2h
W*
W* + 2h
Wealth (W)
25
Risk Aversion
U(W*) > Uh(W*) > U2h(W*)
Utility (U)
U(W)
U(W*)
Uh(W*)
U2h(W*)
W* - 2h
W* - h
W*
W* + h
W* + 2h
Wealth (W)
26
Risk Aversion
The person will prefer current wealth to
that wealth combined with a fair gamble
The person will also prefer a small
gamble over a large one
27
28
U(W)
U(W*)
Uh(W*)
W* + h
Wealth (W)
29
30
34
35
37
U (W ) pU ' (W ) U (W ) kU " (W )
kU " (W )
p
kr (W )
U ' (W )
39
U (W ) b 2cW
41
where W > 0
Pratts risk aversion measure is
U " (W ) 1
r (W )
U (W ) W
42
A
AW
U (W )
Ae
43
44
45
for R < 1, 0
R 1
U ' (W )
W
W
49
Utility Analysis
Assume that there are two contingent
goods
wealth in good times (Wg) and wealth in bad
times (Wb)
individual believes the probability that good
times will occur is
50
Utility Analysis
The expected utility associated with these
two contingent goods is
V(Wg,Wb) = U(Wg) + (1 - )U(Wb)
51
Prices of Contingent
Commodities
Assume that the person can buy $1 of
wealth in good times for pg and $1 of
wealth in bad times for pb
His budget constraint is
W = pgW g + pbW b
pb 1
53
Risk Aversion
If contingent claims markets are fair, a
utility-maximizing individual will opt for a
situation in which Wg = Wb
he will arrange matters so that the wealth
obtained is the same no matter what state
occurs
54
Risk Aversion
Maximization of utility subject to a budget
constraint requires that
MRS
V / Wg
V / Wb
U ' (Wg )
(1 )U ' (Wb )
pg
pb
Wg Wb
55
Risk Aversion
The individual maximizes utility on the
certainty line where Wg = Wb
Wb
certainty line
Wb*
U1
Wg*
Wg
56
Risk Aversion
Wb
U1
57
59
62
WbR
V (Wg ,Wb )
(1 )
R
R
63
WbR
V (Wg ,Wb )
(1 )
R
R
W*
U1
U2
W*
Wg
65
W*
W* - h
U1
U2
W*
W2
W1
Wg
66
67
68
69
70