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Selection
In economics and finance, the most popular approach to the problem of choice under uncertainty is the expected utility (EU) hypothesis.
The reason for this to be the preferred paradigm
is that, as a general approach to decision making
under risk, it has a sound theoretical basis.
Suppose an individual at time 0 has to decide
about the composition of her portfolio to be
held until period 1, and that there are N assets
which can be purchased, with (random) returns
Ri, i = 1, . . . , N .
If the initial wealth to be invested is W0, she will
have wealth
For
W 1 = 1 +
N
X
i=1
xiRi W0 = (1 + rp)W0
in period 1, where rp = i xiRi is the portfolio return, and the xi, i = 1, . . . , N , satisfying
P
i xi = 1, are the portfolio weights.
P
x1 ,...,xN
subject to
i xi = 1.
N
X
i=1
x i Ri W 0
Risk Aversion.
Definition 1 An agent is riskaverse if, at
any wealth level W , he or she dislikes every
lottery with an expected payoff of zero, i.e.,
E[U (W + )] < U (W )
(2)
In general, the risk premium is a complex function of the distribution of , initial wealth W ,
and U ().
However, let us consider a small risk.
A secondorder and a firstorder Taylor approximation of the lefthand and the righthand side
of (2) gives
E[U (W + )] '
2 00
0
E[U (W ) + U (W ) + U (W )]
2 00
= U (W ) +
U (W ),
2
and
U (W ) ' U (W ) U 0(W ),
(3)
is the ArrowPratt measure of absolute risk aversion, which can be viewed as a measure of the
degree of concavity of the utility function.
A related question is what happens with the degree of risk aversion as a function of W .
Since Arrow (1971), it is usually argued that
absolute risk aversion should be a decreasing
function of wealth.
For example, a lottery to gain or loose 100 is potentially lifethreatening for an agent with initial
wealth W = 101, whereas it is negligible for an
agent with wealth W = 1000000. The former
person should be willing to pay more than the
latter for the elimination of such a risk.
Thus, we may require that the risk premium associated with any risk is decreasing in wealth.
It can be shown that this holds if and only if the
ArrowPratt measure of absolute risk aversion
is decreasing in wealth, i.e.,
d
dA(W )
<0
< 0.
dW
dW
Essays
Markham,
000 (W )U 0 (W ) U 00 (W )2
U 0(W )2
< 0.
V (, )
> 0,
and
V (, )
V :=
< 0,
Example
Consider random variable X with probability function
p(x) =
0.8
0.2
if x = 1
if x = 100
0.99
0.01
if y = 10
if x = 1000
To make analysis reconcilable with expected utility theory, we have to make assumptions about either 1) the utility function of the
decision maker, or 2) the return distribution.
b > 0.
V
= b < 0.
V : =
or
2
1
2 +
const.
b
> 0.
V (,)=V
mean,
1/b
V = 1.5
2
V1 = 1
1
0
0.5
1.5
2
standard deviation,
2.5
1
exp
U (W )
(W )2
2 2
U (W + )(W )dW
= V (, ),
where () is the standard normal density.
We have
V =
dW
Z 0
Z 0
0
> 0.
d V (,)=V
V
<
1
1
U (W + ) + U ( ?W + ?)
2
2
!
?
?
+
+
U
W+
.
2
2
+ ? + ?
2
Liquidity
V[(+*)/2,(+*)/2]
( + *)/2
V(,) = V(*,*)
( + *)/2
Example
When normality of returns is assumed, a convenient choice of U () is the constant absolute risk
aversion (CARA) utility function, given by
U (W ) = exp{cW },
c > 0,
where c = A(W ) = U 00(W )/U 0(W ) is the constant coefficient of absolute risk aversion.
Then,
(
E[U (W )] = exp c +
c2
2
2 ,