| Microeconomic Theory Uncertain ves Pact IL Uncertainty Letures Pact ID Marschak - Machina Triangles : Consider the set of all loHeries or vicky assets over three fixed outcomes, viz, %1, Ap and %, cohere X 2%, 2%, hat would these tcHlener Jacsets/} rototshh Aichibutions Wack like ? They should look ike bs Chr bs, Ps) where as probatily of outcome 2%; and ge port. ble know then that py = (pi fa. Hence, geomeenlly we can represent these probetihly dishtbudions over 1,42, %3 omtcomes usin sinds te the unit tangle in te (pr, fs) plane 4 increasing Chg? +: 3 Fa. f preferences | 53, >), > prob %a) Ge, when you iow vac, gee go deeb bi ° 4 Poudeome be hespmete? fete a fats oll cee Seis ag, ves S3,.) Upward movements in the tangle inerewe ps 4) the expense of pa; leftward movements increase ps at the expense of pr. So, amy leaned si upwind rmovemant mans bali ttlees. How do T read any poir! hee? Fader vecitzal The base voy ead the arene axis value of the point as pf and the vertical axis value ac ba, ad t= bi-bs aS shal are the in Hereaee ewes? — They ave the loci af solutions + the equation (ee ia ili: from EU Sorm ot N-M ne function) :1X1) & Cl~fe-bs) ular + sacs) = a dr different values of the constant ‘c’ What should be the ar of his. indifference carve? Recall: N-m uilidy dunction: U¢b) = & uC: 2 fpiucad tc put) From total difserenhation: {I + pauers du=o 5 ucm)db, + uery) (-dby - apa) + lds) dpby =o => = Cucx2) - wea) dp, + Cucazy - ucaz)) 4 a > $= UAL) = WH) > es “ulas) ua) Cgtven that 43.72%) This is the slobe of the indifference curve. As HH Is positive, the indifference cures should be upward sloping. Nabe Observe cavedully thet the slope axbvession cloes not have pi or ps ; a slopes ave unaffected by changes ia fp. Ther the indefferance curves ave parallel traaght ol Increasing in value in the norlhwest direchon, We can rewrite the slope of the indifference curve pe UOa,) — UO) HUCTe) —uCK) + 46%3) -40G) WC43) — ulx,) Chasically we ave adding and subbactng Ulta) and ucas) ) Hhat do we get from this seeming “insanity P -UC%3) Fultz) + UlX,) ~ UO) Utz) 40%) Ul%a) — ul4,) (Alay) 44) > - (ucts) - cx) — Cucds) - uct) a Ula) -UCA%2)Leaving aside 4, the fist part is a clisevete axologue of Atrow- Pratt coefficient af absolute nish aversion ~ WON vox). Ide know that Cmay be later) the move risk averse fs a DM, more concave hisfher Bernoulle catili duncton Lecomes, then higher is te Arrow Pra eortficient of absolute risk aversim. Then, giver two expected ally maximizing Dis, the one with the steeber indifference “curves will be prove yvisR averse. let us draw out anole subtle interpretation » Recall expected valug of a lottery f= Chr, ha, bs) 3 ee Ect) = Se peme ier Py prxi Clb, —p3) wre + ps Ag Then, we can also feure out what the iso- expected value (ies should be. They should be solutens t Xr FOC bi ~ fy) Hab py zy = Constant by vaging the conshets, —“ihat should be the slope of these” iso. expected value lines? Xa. —¥) os =e Concavity of ‘a’ should toll ws that UCAr) — UCAi) Xs —2y & O%3)= alae) Sag eee By My hs My. Novth east movements along these lines do not change the exbected value of Ieeries but increase the probabilhes tdthe tril outcomes x, and X5 at the xxbense of the midelling outcome %,. blhat ave ou doing then? Yor ave preserving the mean by tohaing webabilily mas Som he mille and Sfreadi th to Gals, Basics Your ave increasing the paved visk. These ave called ‘mean preserving” shreads vars)Search increases in pure risks will bead to lower indtSfevence curves Sor risk vere DM. [By same logic, such increases in ure risk Cmove ment mim tso- expected value curves towards orth east) will” Lead 40 higher indidference carves doy ith lovgg DMs. Vy ES solid line: cadifterence’ curves dotted line: ts0- expected value lines Steab tadHerence cues af visk avere DM Flat indifference curves of a Wak lover. Again you can see that the DM who is move risk averse possesses steeper indifference curves. There is yet another subHe point here. rf is nol so much the linearly of the indrfference curves thal matte; But that their slobes bev area] ey than the sted iso- expected value lines xo that. it it necessary end sufheioat dor all mean preserving spread increases in risk to make the DM wsorée off. So, you can imagine non-lineay indifference curves ; but theiv tangents) slobe eught te be everywhere steeper than Ih iso~ axpect value lines, hat is driving the linearly 19 probabilities ? Consider utility function v', uv . is Itneat Then, take o” yo uo lotteries hiv ale on bey Chere p~qy). Now take conver combination oh qand ¥ as well as foand Y,Yu get ay tidy and Apt Cet) y, Nous, Apt City y¥ axgytCi-ayy AS kp CID lies on a hegher indifference curve, This viclates the tndebendence axiom as ee (here bw 4,) does not mean ee pkey % xy bed) Y. Tn order + restore the independence axiom, wa need the indifference curve OU" 4> fais fbrugh oc prey; that is, we need UO" 4y be parallel of Also, considev ‘~ q' as both eve on the IndtHerence curve U. By independence axiom, Ap! + cindy y ~~ «G)+Ci-a) y ee ) So, any convax combinaton belveen duo point on the same indifference curve must be on that carve to. This will hafben wilh lineay incktterance curves. If we instead had a hon-lineey indifference cuvve wu that is passing through BI, 4! then wa gat p+ cia) g! ery y' , as v' lier above vo". Hence, non-lineay indifference carves violate the indebendence axiom. Alteinahvely put, any viclaton of the insepencoce axiom will mese up the linearly of the indrfference curves in probabilities. But, “that in itself chould not bother us, as long as we have the slope of the ent + the honhneay (ndifference curves fo be shether Rverywhere than the jso- expected value ines whenever you consider MPS increare in pure visk. Let us now explore the violations. Violahons of linear abilities : In ordev understand the general structure of venous experiment violations, we need + undershrd dirst Sepmabilily across mutially exclusive eventthat Is inherent in N-M Eu theory, Let us break it inte two propertes : ¢) Replacement separability and and ci) Mochue se] wali. Replacement separability : As the name suggests, this follows fom the additive Structure of the EU hen 2 p,. uct) and the duct that the contibutin of “each pele els pay Cpe, %) te this sum is independent of” the other outceme/ robabilily pairs, as shown below. bs a pect pale ta 4 7 Simple } ery e bo wots) Conbibuhon of each P : . cam Mh par Pr Ucn) Rie d Pte Soke alee HE ca . t b.. [asacr, t44oy)] Contibuton of ° each sub-ltHlery P Xa ‘phe ae 2 Se iy bo [1 u0s) + ao)] Ife pM byaters to replace Ca br) by C91, pi) above, Cire. 1 loHery (91s pis %aepay- Anspn) 75 prefered Cary pis Ar, paso Hn, bed) Inen he would also pveder to yeplace C41, pi) by (9 pd in any othey lottery of the dorm Coys pis oh bE, ae a) This will be tue even if one ov more outcomes of C%1,... xn) oF Cosy. 0,8) fake the Same value as A or Y,. Mixhwe sebarabilly : Tt follows from the fact that the contibution af zach outcome / probability baiy ts EU can be interbretedas the utility of tty outcome, utac) mutblted by ats obabilrdy pe Because pucy,. > bf, Ucn) => uly uu), an BU maximizag DM ast Il prefer Cy, > brs 2) fais 2m, pn) over Ct, pri Fay pas - pin pr if and only iS he preders yy tn an ough choice over these fuo sure outcomes. These sebarabilty notions extend 4 seam mutually exclusive surfatteries oJ a compound lotte, Contribution of sack sub-loHery fo the Eu of « compound loHery i6 tndebendent of te ofber sub- lottery Cor sub-lotteres) in the compound lottery. I$ an EU maximizing DM prefers fo replace the upper sub-lotley Cia the second diagram above) by Hs 7 I. , another sub-lottery, he if nx, eas aaa Vi As = ho, then he would prefer to make this replacement for any othey condiguyahon of lower sut-lotlery in the diagram, which is nothi but veplacement barat “over cubletlead. Now, ffom the diagram, + ts clear that the contibution of each subletlery fo EU can Le interpretel as the EU of subloter multiplied by its probabildy (say bi Ov pa). Because bi [44 Cao + dz alya) + 43 ucys)] > b Lauct d+ q240)) ity [a uly) + An wcy) + Ja, wen) > Lamont gacsy| an EU maximizing DM will sxhibit fre breterence in”the above diagram if and only if A Yr yy ay 4s ee ta an oubight choice Lehween frese two simple lotteries, This is mixture Separability over sublotteries, Independence xxiom is a combinakon of the above duo separabilites across mubally exclusive outcomes and/or subleHeres. The axiom Cind ependence) and hence he above two arabilly properties is eyuivelent to the pavperly Mat NOM utildy functor takes the Expected Otildy dum : U Cp) = Epc), Violakons of separacility : Allais Peradox:. Consider a,: 4 chance of 1,000,000 versus 4: (0.1 chance ef 5,000,000 ©.89 chance of |}, 000, 000 Jets chance sf 0 and a3 : §e! chance of 5,000, 000 64 chance of O Versus a: 13 chance of 1,000,000 0-384 Chance of © Make your choices. Letting § f2,,22, 43) = § 051,000,005 5,000,000} these Souy gambles will Soom a parallelogram in the Chi, fx)” plane.4 Experimental evidence: A, and 3, If you chee ay over | a,’ gour indefference carves ave [Ax 4s steep and hence you should ° have chosen ay over A a 4% © re you had hte inde teres curves, you should have chosen a, and 43 ja the two sthvatons given 4 you. Let us present these stliahons differently now, y 5/080, ol 4,000,000 eae oil eee a, —<— vewus a, a Ti~o mea 1,000, 000 Bee and 1ofr__. 5,000,000 oN 7 e bo. 1,600,000 a ¥ Versus a sq + oan ° 23a You can see that Allais Paradox is Violating the independence axiom, If you Itked Co. 11, tye09,008 ) over © \) chance of 1%, 1 51000000 5 fy then ivresbective of the irrelevant third option, “you Should choose the same. Ifowever, you have Hipped cif you chose a, and a3). This is also the violation oH replacement separability over subbtere as the choice of a, over a, imbltes « prederanc Sov replacing “ppey sublotary in a, by « sure outcome 1,0, 080, when lowey branch ives 1,000, c00. However, chotce of 4a, over ay Vnpltes an wnwuillingness te do the same when the lower branch Gives “20, In the diagram such violabons (ay, and ag choices) can a whea indifference curves stb being parallel and instead San out.Leb us take another approach + understand the above vielation, You can visuahze these loferics as a coin toss experiment. Len ‘heads’ you get fo play Sy. and when nile somathing alse CGAY aecebendinea axiom falls you that preferences over what would h when ‘head’ oe should not depend on what would oN hebben wher M1? abpears. To make it cencrete: a, x 2hvee00 F CH- ON) SL VRysus Az + ONT 1 vat, 5000/0005 30] + 01-01) Oy woe, Nea: - ae. BIA [ [8-52.00 pe] teresa eo Versus Ay = 0." Ld ®abwyose] + C10. )bge x0 Okiously, when the DM is belter off in the event of tail (1,000,000 versus Zero), the more risk averse he becomes over what he would got in the event of “head! hen the tail payoff becomes low, he becemes were less yisk averse. ‘This fhenomenon, vid. « swing in preference from more visky less risky subloteries in ene branch of compound loffery as the sublottery in the other branch imbroves in the sense af Aut ordey stochashe dominance [_ probabilily of Letter outcone betley] is called as ‘ common consequence effect’ An alternahve interbrekhon is that, given DARA, in the Common consequence effect, 4 disjolays more WER aversion jn the event of an obborhinit bss, and less risk xvertion in the event of an Opporhinily gun. The next Rind of Wolaton occurs on acceunt of viclaton of mix-ure Separabillly. J ee . . ' 1S % chance ol Consider a, + Saeacetich versus 432 aiact 5,Tp chance of X Sty chance of ¥ Mig:< y pia Sy erp chance of 6 OM 44 ake where Pr ps2 Of%LY and otra: outcomes ave fo, 7%} and lotteries can be yepresented on this outcome Space, Didderently representing the same IcHeries : bx ee) a Versus az os en ; hp -F@~o and Yi Xx ap: a, see ° venus Ay ja O 1-7~ ° I-r~ © From mischare. ssharability, you would choose az over ag “Ahoncuer : y [ pace) + cp) co) | > [4 4cy)+ci~y)uco)] <> pfaex) 40] > gy Pucgy — ue0)] Alternatively, 44 over 8) neler even ag and ay oer 4 ee Pe eal However people in. te experiments chase Gy a, and a. This phenomenon Is Rnown as ‘Common watis effect’. the ame comes Sam the tack that prebCA)/ tui y) in ay versus ay is the same as in Az versus ag, In case you are myshdied, here is ancthay eaunple, choose beween 2000 For sure veysus 2-8 4000 0:25. 3000 choose behuson 2 5 venus os Peeble in axbeviments choose 3000 for sure and doy) chance of 4000. Here, the Sam is like: (Yb o!—b) and Ca, Api ©, 1~Ap) where x >4. Here rot i constantodds and ends wih N-M_ utility Aincken: Is N-M utility ordinal ey cardinal ? Even though we uce the tum ‘utlily’ in the ey cones vs ubldy ts distinet pe ep ordinal utilely function consumer the Breneva| eguilibriam Iheory, ok en distinehon lies in reid 4's that “ke latter a defined on the set of consumfton bundles /oulcemes , wherers the former CNM bly) is dabaed on Ihe space. af probabilidy distibutions“Nen\ "outdone Space. The second crucial difference is“ that the Latter — uledy consumers) can be subjected 4. any monobnic transformation, while oe wkilidy CH only be Spas + attine ; deans dovmahons “Cue. «0lx)+b, boo; vib, “ Chenge 63 ongin and/or scale; but do aa charge the shape of the Aanction). Te, that extent, His cardinal; yizl, the EU properly 18 cardinal, Is it « probability Aanction or an etildy Sanchon? Recall that tn the foroof of the N-M theerem, we took uct) € Lo, 1] and called if an elementary uhldy dunchon. Does 4 mean that the atl, Sunchon of “monetary outcome is bounded behveen o and 4? No. It can dake any value due to affine fyansiormaten, Example: Lott Lahey J asset A (asset B ae bea) 2 pcx) s Sr & x lo %, : 2 ti H wes) 2 a? Then, B,uct)= +5) + Ler = 42-5. | 7 Egucx) = 4, cays bf Wi ux) = loox E, 4, C1) = 62-8 x10 = 6250 1 ‘ = 6f00 Ep Uy lx) = 64x 100 . cin) area) = 100 +t" , here b= -/00, @ =!Reduction of cempound IcHleries ; Note that the agent is alusays indifferent between any compound pies and ds probabilist cally epuivalent sidgle stage ‘simble’ lottery That is, ¢nherently we are assuming that ‘the sequential nature of choice in a compound lottery does not vequire significant mount oS time. ; Example: mH x aan bh bit pri. ps) : Va - 2 fs ta > tae ta Xa He ave ignoring the ‘hme ail taken 40 perdocm first and subsequent randomization Che Chupa) aod then C442) or CTs) and also ignoring the sequential nature oF the sitsetion in the combound lottery care. Eriven this tmplretl axiom, he EU of both the compound lofley Cwhich is< malki-stege one) and the equvalent sible loHery ¢ which is Single stye ene) are Ine same: big, 4 Ce) + bi G2 Cas) + p27 Mts) + pate UC ry) This is of course, ‘lineay in probabilthes? which means that EO fereterences exhibit separability across muraly exclusive events.Money lotteries Henceforth we will fake it that risky loHertes yesult in outcomes expressed (nm money terms, Let us take monetary outcomes as a conknuows variatle. Then, ary lolery can be described by the cumulahve atstibuhen fanchon CepF) F: IR —> Lot], To vecall, Fla) is the ae that the realized outcome is less than oy equal xy te. Pexy ("Pade ae bes We will view ouv space af Ietedes as space of all diskibuken Sunetons over set of monchany outcomes As usual, UCF) will be N-M uly funchon over loHtedes, or eauivalently CDF and uca) will be Bernoulli ubldy fanchon el" SiPcomes x, x 6%. OCr) = Uc) d Fox) EK Bernoulle ability = wea) £oa) dx xe Fel density Sunchon Let us recall Tensens ioequalrly . Consider a real valued funckon 'f' “Gad any rvandom variable Cr.v.) %. This inequality states th at BL Pte). 2 #LecBol ih Pee In continuous terms, ae Sucrsordx 2 ul fxdearax] Recall that $ is concave iff rE C1) and ¥ CAA) ce alone alt rfea) + Ct-rn) feb) 2 $ Crat G-ryb) 6 Note that the ‘if4' statement in D fllows hom the equivalence behveen (0 and @ when ¥ is binary and dichibuted as (4,A; b, CIN). OF course, Jensen's ineyualey extends this dediathon fo any general nV,Remarks: GO) TS f£ is convex, tea 3 vv. F we E[#eE) = £ Leck). (» To ay Jensen's inequality, we do not heed ty know whether is diHerenbable er not. However, if itis, then # is concave iff $f" 20 when domf = IR, Definthen: , Call a risk ‘achanally Soar’ oy * pure risk’ if it has mean zero; je ECE) =o Dediathen: A DM is risk avese. if she declikes all mean Ber risks at all wealth levels. Let the DM's a wealth oe Let hey engage in risky actu /[ote, denoted by the Oe Then, final — See is ye rv Hence, BE ut wt %) ull ECwot®)] OL w+ EcX)] = u (ud) AL BCX)=0, Ser all pure risks, Equivalently this DM is yisk avere if and enly fo EucE 2€ 4u(6cd)] fr all nv & representag foal wealth F = woth ; ECE) =0,, Hence, a DM is risk avene If replacing an uncertain. final wealth by its expected value Dect her better off. From Tensen’s inequality, this # Is tue and only if Su’ is concave. Hence we have the Sollowing result. Result, An agent /DM =e with Bernoulle uklidy dunchon UL) ts ae averse if and wily if utr) is concave. WY an agent is ASR loving If F her utile) tunchon is convex “and yisk neuve! iff her ublily Aincton (Ss hnear. HonRisk Averse DM ule) wee) fec3) 2s) wg cect) 7° cece) 5 ack ¥ mE) = eck) - cack) Deginth on: 20. Certainly equivalent of a lottery, sey 3, wie, CECE) is the amount of money for Which the DM is indedfevent behveorn the gamble and the cevimn amount ; ve. =U CCECE)Y = EUCT), In terms of CDF notxton, u(ce (Fad) = {aon 4Fey = fue $ca) dy. Note hat uCec®)) =z & uc®). So, in CDF notation: cecru) 4 [x dFtx) ¥ F means DMis risk xs KAKO) Seer Let us check fit ts tue. cecr,u) 2 fxdrFer) C2 wlee Cha) € u ( fade) <> fucarydroad 42 uC fxare) “UW CceCFuy) = fucsydery) which (s Jensen's inequally, a dedsathon of ce dekniton of DM's risk aversion charackershe . DeSiathon: Risk premium To is the «mount the DM is willing 4 pay fa ordey t avoid a pure risk. eee visk averse agent, risk premium W is posttive.That ts: EuCwt%) £ u[ecuwrX) -1] = ufw.-7] Using Taylor series abproximahon, LHS. is: Eu Cudy + L) _ [ucwse) + uleud) 3X 7 ullCwe), oy... es des gate) + w'lude) BCH) + uC.) 23) ree a ule) + SH y"Cw) fas ECKa0] 2 Using Taylor series abproximakon, RAS is UC Wo -T) = UC.) — TT. ullW.) 4 -- es 2 Uw) — 7 u'cube) 1@ Equedag LHS and RH.S : US) + S% UlCwe) = — UCwBe) — 17 u'Ceby) 2 i» = — rei pies o U' CW) ce Crd (2 u"Cuds) 7} r 2 vicw.) 4° Deginiken: = Ralito) aun) Lirias) ce) odes. ass aE coedhvieat of “absolute risk avecion . As you can see, if nish aversion Is eajshured by fhe concavity , Hyen a measure of nsk aversion should ‘eitert of, o cApluve the “concavily, Lhy act ou" alone then ? a Tt will not be immune fo affine transformations, Note that Ula) and waeauta) +5 ave same dor us ; but,u"ox) and au'ex) aivding by lcd int a pbesikve number ave didferent. and minus Sign as ull) is Relehen bebveen CE and Ris premium How ave they related? Trinal. ucce¢e)) = Eucé) = u(ecd) -7) CELE). = BLS) =T] Hence, we ave ust converts iF ahve. eel), = Caray x, alta) 2 gice) =o as ECR S12, Differentate © once again werbe k: EL ul Cato tk) | aff g'Ce)] * u'Cwe —gck)) —g' Ck). us 'CuS,, -4Ck)) => grtk) = - uw! Cw) ecx*) uiCus, ) Using Taylor sevies expansion of g wud k=o: Ww aiayaty ER gtk) ~ (ate) + kai lo) # he -g) rte Paya) y= +. EC¥*). Ry Cum) It says frat risk premium for small pure sk is abbesximalely —beoporlional 4 ils variance. As size 6¢ visk k tends te 200, rvisk premium tends + zero in the order of k*. This is what is Rnown «as ‘second order risk aversion’. Usiag cl jedsnithon ; 8 ced a, RCR+R)) = RR - & RY. Rabo). £65)20 For small R, CE of risk CHER) equals AP, aad the riskiness of the situaken does nef matter Note that what we have Sy Tis an Ap proxi makon. This abbrxtmaton (ir = + EtY*). Rl)) works dine as long «1 k £4. For lacger le i andereskmates true T. Crudely put, Rp Cu) measures the maximum amount that a 2M wih wealth wo, whildy 4 is yeady te pay to get vid of « small risk wilh variances, (in owe 7 apprximaton ). Comparakve Risk Avecion across _pMa: He want fo compare two DMs and want to say when one will be more nik averse than the other, From our discussion of Arrow- Pratt cocthieienl of absolute risk aversion or risk premium, we know that DMs is more risk -averse than pMa2 itt Ra Coo) soy pM) 7 RA bute) for Doz. rf So, then TT Cue, u,, X) > TT Coy, 4, ,%), lettin boy's utility 45 be uy and DM 25 te be uy Leb us dormahze all this row, crude Definihon Cverbal): Suppose uy and Uz have the same inital wealth. DM uy, is more aise averse than DM uz tf uy dislikes all loHeries that uy dislelees, independent ed their inthal wealth, To characterize this notion ‘more risk averse’, dedine a functoa P such that ptu) = aCus'cw) ¥ u Because uz is increasing Co u,!>0 ), $ is well Aekned By dedinition: wc2) = Cusce)) + 2 Thevedre, cb transdorms «Ug. Info Uy.2 Also, aiC2) =! Cuca). us ca), > icuc2) = WA), 503) RAS. is besitve as beth u, and Ur ave increasing, Hence is lncreasings Is $ concave ? Differentiate 4'C2) = o'Cuzca)) uy!Cay eae u"C2) = oon 2°C2) ) [u,'Cay)7 + # C4020 a ey = Plager) (u'r + 42). u,"c2) uittey 3 Divide throughout by urced: eee ah ulcey 4. uaa) uy ue = $! Gusca) £ ay 2 uy ce) “asiee) i => uly uta _ Sac ast) u,i€2) aa} Now, u,'>0, uz. so, fslcel7, 5 a ésay) "C2) _ usta - $'Ca,c2)) ute) PHEY) UEC) Ue. 5 trek ia. tat u'C2), u'c2) DMI > Ry of DMZ, thon LH-s. 's pesthve. > 4"Cace) 2 o. So, > must be concave iff Ry of DM, > Ry of DM 2, Consider now any risk X tel fs dtsliked by DM2 That is, Eu, CWotX) £ u, ( & (wet x) = Wz Lae). Since is Increast and concave, Jensen's jn ality tell mae: 4 ce22 E[ucmix)] = EL ocuy €4304%) ) | 4 [e Ca, (wot )) | & Cu, ¢w)) U, Cwo)- D> concaviy of 18 sufherent te grersatee thet ) Arshkes “All risks that u, dislikes. Concavily of b & also necessay. If ¢ is not concave, then 3 an interval a the image set of tae where = ou, Cas'G)) 1s | convex Consider an inihal wealth uo and leery 3 has its support ta that violatiqg caterval 4. Euzl Wot) 2 us cue), “using Tenrene inepaalidy as above but with locally convex ? ytelds the resuif frat ou, likes 3, meaning she is more prene te risk than 4, , a conbadichom Hence, we conclude that u, is more risk averse than uz fF ou, te a concave transdermahon of ty, Ee we assume that these two wW,4, are twice dcbiterentalle, "20. That ts, glace) os ais [ Ra Cun) ~ & Cu,)] 2 where Ralis) = = 4y''Ce)/, iN nit Abe Woth (ay uly and Balt) = — WEY cay is concave (44 Ry Cxr,) > Ril), ng nll thr, we get the follousing result Se, conclude th at Sammandi Results Sabbose us and 4% are duce alfferentatle. Then, the Sollowing are equivalent : ci) DM uy ts more uk averse han DM uy, cil) Uris a concave transformakon Up GB) RACH) is umidormly Maraer than Ra Cus)23 This yesult should also mean that rcu,) > Tee) and CE, CH) « ce, cz). Let us see how jf works gor isk premium and Cerbrindy eynivalent, A more risk averse agent ouphi f be wsilhag te pag higher risk premium te escape a given risk. Suppose ou, is more risk averse than “Uo. Then, fe show: T( 20, 41, %) = 7, Z Wlte,u, X)=m, ey EUs CP4t¥) = us (26-72) SD. pC te +) =) wes. Sa 5, 1 reo, RWS = 7, 7 ie, Define Bs, = 2 =-T, and Ya B47, . This *s then equivalent tu, ecting all Inttenes dor which uz ts iadrfterent, assuming they have same wealth u%. Lie know thal this is Hue ; ard only if 4, Is more concave than uz. Summarizing tars lato the Following result; Result: Agent uy is ready & fay mere nsk premium, he, Tr Zin for any u9o,% Fe 4 is more Hsk averse than Uy. This result should alse mean cac#) 4 ce G) gyen thal 1 = eck) = ce cxy.' : Attevnahve Prof : U, Cee, CX) = ELa, eX) As wey) = Curc-r), 4 Cee, 6%) = Ef pcuc-r] £ fe Cured). Bet Efuscy) = a fF, CX) . So, wee, CX) 4 Lu, (ce, ¢x)) DS Ww lee 6) 2 a feu C11=> 8,00 4 Cey GX) iL Pecan => Wu) 2 T4g,%) — Le dedn comechg i and cB). Comparakve risk aversion across Wealth: It is usidely belteved that the more wealthy one is, the smaller rs the visk premium, This corresbends te decreasing absolute risk aversion Cosa). Dediathen: Pregerences exhibit DARA if the v1sk byemium associated with any risk is a dacreasing Function of wealth: fe. STH) 4 6 for any Woy X. 3 We Recall: Fucus +%) = UC. - Tl, u,5)) Differenhate werk. ue: Buller Ht). 4 = a'Cudy-Tlde,4,5)) «Ci = Bmw 2X) ] > eu'twothk) = ult.) - u'C.9aT 5 %%we = wiCweaTen) = Bul u' Cade = This is negatve if Eu'(w.t®) 2 u! CW.) => wwe, Wak, ‘ EuCutet®) = uC wo —T) > cults rzutga) This is hke puy zarher result wilh uz =a and Uosc-u. lthat ts oa! 2? ule -u" ; bit ul ze as U is concave. Hence, u,' yo. uj =" sill Sey Hence, -ul is @ concave Sunchon, Lie brow that Chom our eavhey yesult) uu, is more risk avene than 4p. Hence, the necessary and sufficient candthen fer isk premium to be decreasing 19 8. 18 tha25 1 —u be more concave than U, bet PCa) = - UMCa) /u"¢2) dencte the degree of concavity of ul. It 13 called Ihe cohen of absolute risk bridence. Now, -u'l 1s mnre concave than u 1f the degree of concaviy of ul 19 uniformly lewgey than tw that of u 5 we. Plum) = ky (ud) This ts equivalent te the condition that Ry be decreasing in wealth + RyhCwo) = Ry Cuda) [ Ry Cus) — Pu ) | For Ra + be decreasing (A aS, Ry! Co) 2 0. D> Plado) > Ry Cad). Let us summarize all thy in the Silleesing resalt Result: Suppose wis tntee deffeventatle. Then the Flexing awe uivaleat. GC) The wisk premium ts a decreasing funchon of wealth cil) The coehhtient of absolute xk aversion t's decreasing ia wealth. eit) =u! isa concave tranrdormaton of u . te. ~ ula) Anca) 2a"), * a, tle can then tk xbout Increasing absolule risk aversion CIARA) when Ry (eS oo and constant absolute visk averion ¢CARA) when Ry Cum) 20. From those dedinitions, ove can uneacth theorems siexd analogous te the one above.26 Relative Risk Aversion. The dundamental guechon behind abseute rick aversion 18: how altitude to rick changes with changes in the inthal wealth, without changes in fhe size & the lery /gamble, ele could now ask: bow cloes abihdle fo risk changes when invhal wealth and the scale of he loHeng / gamble” change together rhonally. fay cour OM B vepvesente ae inereesing concave utility functon, which is Voice continucas h Aibterenkable. He chooses simple probasilitly distibuten over outcome space. bet uw be Ais inittal wealth. We will now consider multiplieatve risk. If he indulges ia the risky achwily /gamble /lHey , his Sine! wealth will be + %, = uw Cit RY) Dedina velakve risk premium, IT (we, u, RY) as the meximum shave of ones wealth that one is reacly fo te escape the risk of lasing a vandem share ky of his wealth, a he. TT (we ,u, kf) = Tor WekZ) We If £c9) =o and hk is small, the Arvow- Pratt Aabproxt mation yields: . uf Wwe, u, RF) & tp ECke) [== eee G48.) oC, Here, — We" ricany IS the ceedticient of relahve risk aversion; we can denofe it as Re Cw) Hence, the relatve risk premiam is cp proximately proportional to Re Cus). Think of Ra Cue) comparing altitudes ts visky lHertes ushosa outcomes ave absolute gains oy losses fom current wealth, By the same logic, Rel) then Compares risky loHenes whose outcomes ave percentage grins or percontage losses of current wealth. The Re tsa Strengev measure than Raj a risk averse DM wilh decreasing Rp will exhibit2 decreasing Ra , but the converse ray not be true. Again, for relahve ask aversion, we can prove “equivalence theorems as we have clone dor absolute risk aversion. tle can also dledine ‘Decreasing relative visk aversion’ CDRRA) as ARR@/S 2o 4 2. This says that the DM becomes [ass nish averse with ard & loteries that ave proportional t hes wealth, as his wealth increases. In the same manner, we can also define increas reledive risk averion CIRRA) ARR, vow 2 and constant reledve isk avertion CcoRRA ARKO). 9 ae An altemabve , intattive interbretatten is that undey ERRA, the wealth elasherly of the pu's demand for risky asset is shictly less than 1. That is, the prebertion ef DM's inital wealth invested in the risky asset will decline as the woalh increases. Onder cRRA, the wealth elastely of Ay risky asset equals 4 and under DERA, it exceeds 4, ble can see all these fymalized fa the next few pages tn the context of fortdelio choice, mand28 Harmonic Absolule Risk Aversion CHARA): This is someligg you might come acrss offen m ney stpleten anlens An tilly fuacton exdibils HARA if the jnvewe of tts absolute risk aversion is linear iq wealth. the inverse of absolute visk aversion is called the absolute risk tolerance ( Tew), ie, Tow) = Ye a8) . rae Consider ucus) = oo (Bt uW/, ) desned on the domain of uw 4.b. pty Sa, Then, u's) = a Cl- 7h (prey) ~” "() = -— a Ci-» + /)~ utes) a Uw) (pty) F ut = cle v+l i u“Cos) a& 2S +!) Cpt) for wizo, v"Zo, we need acres >, ‘ - Wy, be Race) 2 - MOY 5) = (P+ %) 1 Tlw) = heey = . PI ~ Pow) = - wee) rp) = ERY Mk Reto) = -ar lls) - “ecpesy” “u'es) Angin parameters and V, one can By ale al wll functions that exhibit HARA. Lef us See thyea sach cases. CRRA: If B=o, Rplw) = VY ahich is non-negakve. Thus, B= 0 corresbends to a siheation24 where yelatve risk aversion is independent of umalt, tia u'G) condition , we can choose @ in such a way as normalize v'C1) =|. That Is, Red CG) ot 5 ee zea Hence, w'cus) can be rewntlen as: u'tw) = ys Integrateg we can unearth: |» ucw) = we fi-r th ve In os if Yar Linen yp 21, ubldy goes Som ob 20 as uo goes fem ot 0, hen yoi, ubhy gow dom — <0 jo 0. Note thal all these atilly Junctions exhib'l DARA: Le Ratw) = = igh Ao: CARA: From Ra Cus) expression , RAC!) fs jndebendeat of ws i. ys +. Then, Pace) = = constant ‘ke’ say. Then, solve the edeffevenhal uation is GG9) re. cheba ceal Las gh ut) = = exh (-Re) fp - All such utility dunctions exhibit IRRA. Quadvade ability fancton, Choose Y=-!. These Rinchons have two peblems. First they can be defined only on the interval of wealth w94 B, since they ave decreasing when > p. Second, they exhibit” LARA, which ic not combakble with the chseruahon that risk fremia fy additve visks ave decransing with wealth,Porttolio choice problem: Consider a portfelto choice problem of a risk averse DM who strictly prefers more ts less C increasing Bernoulls utility danckon). If the pm vinvests ay in risky aset and W@W, — £4;) in the ruk See accet, her “end of the fered! “uncertain weal will be: wo = Cle = Bag) he) # 2 4 C47) A Lares pide Ci) 8 FAd CY; -G) where F is the vandom rate of return on fr ritky asset and % is the risk Sree yate of return. The DM ante: - [aQwocmper gay Oy -4)) rg Since De is risk averte, wu fs Concave, and fence Foca ave also sufficient. They are: e[v'c®) CF, -y)J =o we A DM who is risk averse and who stictly presers more to less will undertake risky investments iff he rade af yelurn on at leas! one misky asset exceeds the risk fren yate of yeburn, How ? a For the DM to ‘invest nothing in tha ricky assets t be an obhmal choice, it 1s eatin that the Foca evaluated at ‘no risky investments? be nonprsthve: te EF [ulcwectty)) CY —4 J] 20 #4. That Is, r al welity)) E Ctp-%¢) £0 & §. This habbens when ay =0 consaints held goede Bul ui 20. tlence, “the above says that ay £0 vy only 1h EC -y) soy, That ts, the DM will avoid any Pe risky investment onl if none of fhe yishy ausets have a shichly posthve risk premium.Let us simpliSy and now allow Sor only a siggle risky asset, and one viskless asset. Then, the F-0.€. simplidies E [ul (Woclty) + a C¥—%y YC¥ -%)] =0, where ¥ is the rate of return on the siqale risky «itet Then, dor this DM fo invest all her weal in the risky asset EL u'Cwoct FM%-%)J] Zo Cr here a = we 3 erhre wealth id investecl in the viskyavel) Now, we want te know what would be the risk promiam that is neeced fo make fhe DM invest all her wealth in the risky asset. To do 503 Jet. us Sirst take Tayky sertes expansion of daetpthin SMareund weit), get UIC, Clty) + a CH-G)) we (ul Cwecity)) + a. CF 1%). Ulap + higher ecber terms Take expectohon now and evaluate t when a2 ah : e [e' (0% C1#%G)) + wu Cuscitrs)) C7 =% | 1a) Reeall that we need an abfereimaton for El ultw.cit¥)) CY - 17) Jzocendihon, Hence, Efulewecu?)) C¥-G)] we & U Cw, Citys) EC # w, ECF —-y)*], tl (ud rp) ) Cusing @) ancl Yamembering 40 multiply by -%) Su lWwonpea-yrwe bape o SD ECYH%) 2% (wocty)) we. e[c?—4y"] where Ry = -u"CVy1G) « LuW-s. is the risk premium and the Ris. ceadchon is alveady familar t us. Hence, Jor the DM 4o invest all hey wealts in the visky asset, the minimam risk premiam veqwived should ot lest be RylwWellty)) a. E [C71]DARA _and risky assel: Leb us now explore the links behveen DARA and the tavestment vn the risky assel, Recall DARA: 42) 20 2. Basically, RAC) should be x shretly deterring function Our iatuiten should be that as with DARA over whe entre domain of Rat), demand for miky asset should incresse as wealth increases. Let us formahee it. Result) C Arrow, Ko.) Ok 4, <6 +2 9 ah w Uo. CRecall: ‘a’ is the amount invested in the ricky asset ) Prood : AM the effimum, i E Lulcwocitrs) + ac¥-%)) C¥-G)] = 0 CY Quo From Implreit funckon theorem, vie a7 Hence, & (uN) 6% -vg) J Lrg) da. et So ee, Sie ae bi os, = eG where % = wolity) + aCF¥-%), vib, the end off period weallt. The denominator +s “+*ve as by risk aversion uC) 20 Hence, sign of Bef, = Sign of [ elu" &)c¥-4))) Onder DARA, when ¥ Z rp, we have : a 2 We lit%y) as the amount invested in the risky asset is shtetly posthve. Thus, Ry CB) 2 Ra Cure City). 3 © Similarly, when ry > ¥, we heave B 4 weCity) and hence Ral) 7 Ra (welt). —3 © Multi ply © and @ by -~WOB)C¥—y) : > u'CB)C¥—-1s) 2B ~ Ra Codec yy) wei) CF ~1y) Cr % zB tg In this case) lw = and UNC) CF =p) > — Ra Cool its) uC) CF 14) 5 Cz te > F in Mais cate)33 From @ and ® we gel: ty & Lule) C¥ yO] > - Ra Cwoc try efile) el nS Cr pb. of F> te must he ia Co) dor an obhmal soltion to extst.) Recall the Fo-c.: ELeCR)CF—17)] = 6. sabshhte in® ie ElutcC¥ -)] 7 ©. Hence, te sign of 44/40, sew. fs positive, thereby letting us conclude thed — F4/Judn > 0. Similarly we can prove the Sollowing : LARA: ARDY, vo #2 > he, cava CARAs ARACI/4g =O ¥2 DS Aa/jw, = 2,4, Note: au Va ¢ay)® —— Ral = -¥ C2). wl) + Cullc2) a ay Teta £0 > ul zo, Relahve risk aversion and risky assets, Aw we have Seen, the propery of DARA js related 4o money demand of the risky asset. Thas the DM with a DARA wy dunction may acksslly increase, decrease or held constant the preortion of his wealth Invesied in the risky asset as his wealth increases. Let us vecall that the Arow- Prat coefhivien! of yelatve risk aversion is: Rpl2) = 2. Ryle). Thok now, fora change, about Increasing velative risk aversion CIRRA), flere, Ake, >So «2. The wealth elasheily of the DMS demand cbr risky asset is shicHy less than 4, That is, the frmberhen of DM inital wealth invested & in the risky asset will decline «s his wealth tacyoaser. Under CRRA, the wealls elasheity od demand Jor the risky asset wille 4 and undey DRRA, it will be greater than 4. letussechw,The wealth elashetly of demand for the risky asset, 2 = Vn °% = 1+ Celeste = Eli rap a, From the enrkor result, we know “Me, = TER gel Substituting it in the above 2 sxpression: ne w0CliTs) ELule Icy 4d] + 4 E [nici ce)" ] = V+ oe —— — rr L = a Flu) oF) Denominatar is postive as uw £0. The numerabor can be writen as: E Lud) C wol ty) + 4 CFG) CF-H)J = Eu") & c¥-y)] Hence , oe “c) B c¥ -¥) [al') FG i > sy of y-1 = spa of SE Lulcd) Bc¥ -i Ny Under IRRA: Re lOoli4G) +aCF-4)) = Re (wocitty) ) if ¥zrty and Rp CWolitty + acy -~G)) 42 Re laycurrp)) if Yery. Mullifly both sides by - UCD) L%—%) te get = wld) & CV-G) = Re (uC) CBI -G D when ¥2 4% uc) WO CY -G) 2 — Re Cae City) CBE -G) when F< tp. From these two and Foc. €E [u'CB)@-yI)] =e, we get: and E [ulem) OC¥-W] =o, Hence, sign oo y-+ £6 eh = ele See Similarly, one can forsve analogens results ef DRRA and CRRA