4 views

Uploaded by Victor Tan

yeah

save

- Ncc Risk Management
- act std5
- 1-s2.0-S030504830100055X-main
- LSI Project.docx
- ProQuestDocuments 2017-07-13
- The Risks of Medical Innovation Risk Perception and Assessment in Historical Context (1)
- wrap-up ch6
- Uneven Power and the Pursuit of Peace: How Regional Power Transitions Motivate Integration (WPS 150 2007) Mette Eilstrup-Sangiovanni.
- Untitled
- … Until the Bell Rings! Perspectives of Agrarian Reform Beneficiaries (ARB) on sugarcane farming
- Services Recovery
- Sapm Risk Return
- Sytch Motion for Modification
- Can Democratic Innovations Improve the Performance of Representative Governments? An Agent Based Model Approach
- 03. Example Risk Register (1).xls
- Are You Getting the Full Benefits From Your Advanced Process Control Systems (2005)
- Project profit as a measure of its success
- Sources of Construction Project Risk
- Geotec
- Fear and Risk in Audit
- IOGP_511.pdf
- 11 Business Studies Notes Ch01 Nature and Purpose of Business
- Introduction BS Final
- SD Approach to Market Risk Trades
- Economics
- Bodhi AOM Assignment
- ERP Implementation in Pharma
- risk assessment
- SOP F.E
- Telkom Dit-keu - Enterprise Management Delivery Audit - 200617
- Articulo Alfabetización académica alfabetización digital.pdf
- Como ser una mujer empoderada.docx
- Calculo de a.n. Residencial Brisas de Saragoza
- hoa cúc
- SAVANA 1201.Text.marked
- 1-2. Thatcher and Thatcherism
- Declaración Anual de Sueldos y Salarios
- Lecture 8-4.ppt
- post partum.doc
- DIGEST 1.docx
- RIT T-4-2018.pdf
- EXAMEN
- Blink Decisao Num Piscar de Olhos
- Dialnet-ConceptoTiposYDimensionesDelConocimiento-2274043
- Comportamiento Del Consumidor (1)
- Metalcaucho 1of2
- Tugas Akhir Yoga Alfian.docx
- la curva kuznets ambiental.docx
- Rpp Prakarya Pengolahan Viii.1
- Afiche Del Daño Del Tabaco
- laporan hasil UKS & PMR 2017.docx
- Muiñeira de Montillón
- 1000 Spanish-English words
- 49101893-Thuật-ngữ-phap-lý-Anh-Việt
- ejemplos.pdf
- Trabajo Finish
- zbirka_ftn.pdf
- 2e49b3b548154c8f98d010565eb7c93dLampiran6SENo13_23_DPNP.pdf
- MSBP RE SIT
- Biskut Lapis Cheese
- Introduction to Latin American Civilizations Notes (University of Chicago)
- Characterizing the Nativism and Statistical Learning Debate
- Science and God.
- "Has Science Buried God?" - A Discussion with John Lennox at The University of Chicago.
- EALC 26300 - Week 9.2
- DocGo.net Pa Oxford.pdf
- Interview
- Rebuttal to Yeo Bee Yin
- Victor Tan Resume 2016 - Please employ me!.pdf
- Chap 10 Intertemporal Choice QB
- Examiner Tips for as English Language 9093 1
- Poems
- Marx Points
- Independence of Latin America
- Budget Sets
- The Independence of Latin America
- Academic Streaming Policy Paper
- ApprovalSponsorship13 14(1) 0
- Systems for TCSH Events 2011
- Systems for TCSH Events 2011
- MUN Handout

You are on page 1of 6

* Preliminary:

. If U(a) is a concave (convex) function, then, for any , 0 < < 1, and any two points a1 and a2,

U( a1 +(1-) a2) () [ U(a1) + (1-) U(a2)].

. Under differentiability, U(a) is . concave iff 2U/a2 0, a

. convex iff 2U/a2 0, a.

. Jensen's inequality: If U(a) is a convex (linear, concave) function of the random variable "a", then

U[E(a)] (=, ) EU(a).

* The Risk Premium: Let U(w+a), where w = non-random initial wealth, "a" = risky monetary reward (=

a random variable), and (w+a) = terminal wealth.

Assume that U(w+a) is a strictly increasing function of (w+a).

How could we measure the monetary value of risk? This can be done using compensation tests.

1/ The selling price of risk: Rs = the smallest sure amount of money a decision maker would be willing to

receive to eliminate (sell) the risk "a" if he had it:

{w+Rs} * {w+a}.

Under the EUH, this implies

U(w+Rs) = EU(w+a).

2/ The bid price of risk: Rb = the largest sure amount of money a decision maker would be willing to pay to

obtain (buy) the risk "a":

{w} * {w+a-Rb}.

Under the EUH, this implies

U(w) = EU(w+a-Rb).

3/ The risk premium: R = the sure amount of money that would make a decision maker indifferent between

receiving the risky return "a" and receiving the non-random amount E(a)-R:

{w+a} * {w+E(a)-R}.

Under the EUH, this implies

EU(w+a) = U(w+E(a)-R),

or, given U' > 0,

R = w + E(a) - U-1EU(w+a),

where U-1 denotes the inverse of the function U.

Note that, in general, R is a function of w and of the probability function of a. Also, from the

definition of the risk premium and given that U(.) is an increasing function, maximizing EU(w+a) is

equivalent to maximizing the non-random expression [w+E(a)-R]. As a result, [w+E(a)-R] has been called

the certainty equivalent of EU(): it is a money metric measure of utility.

* Risk aversion: (Pratt)

By definition of the risk premium, we have

EU(w+a) = U(w+E(a)-R).

A Taylor series expansion of the left-hand side gives

U(w+a) U(w+E(a)) + U' [a-E(a)] + 1/2 U" [a-E(a)]2.

A Taylor series expansion of the right hand side gives

e-r (w+a) . Definition: A decision maker is said to be risk averse (risk neutral. it follows that [-1/2 (U"/U') V(a)] is a local measure of the risk premium R: in the small. In other words. . r = 0 (risk neutrality) corresponds to the utility function U = w + a .r or U' = ec e. This can be written alternatively as -e-r [E(a)-R] = E[-e-ra].risk neutral behavior (R = 0) corresponds to r = 0 and U" = 0. r > 0 (risk aversion) corresponds to the utility function U = . r < 0 (risk loving) corresponds to the utility function U = e-r (w+a) Note: Since e-r (w+a) (= e-rw e-ra) is proportional to e-ra for any w.risk averse behavior (R > 0) corresponds to r > 0 and U" < 0. or risk lover) if R > (= or <) 0. it follows that changing initial wealth w does not affect economic decisions.U"/U' = .ln(U') + c or ln(U') = c .risk loving behavior (R < 0) corresponds to r < 0 and U" > 0. Note: Consider the definition of the risk premium R under CARA: -e-r [w+E(a)-R] = E[-e-r [w+a]]. In other words. Note: By definition. R is proportional to V(a). a concave utility function.r. Since U is defined up to a positive linear transformation. Under CARA. it follows that: . In the neighborhood of the riskless case. This implies r = . From the above discussion.ln(U')/w. under CARA. this implies R -1/2 (U"/U') V(a). .U(w+E(a)-R) U(w+E(a)) . CARA implies zero "wealth effects".U' R.r or U = ec e. i. a convex utility function. Given U' >0 and E[a-E(a)] = 0.U' R. which implies that the risk premium R is not a function of w. a linear utility function. where V(a) = E[a-E(a)]2 > 0 is the variance of "a". r = . Thus. Define r = -U"/U' as the Arrow-Pratt coefficient of absolute risk aversion. the risk premium R can be approximated in the small as R 1/2 r V(a). * Constant Absolute Risk Aversion: (CARA) (Pratt) By definition. CARA corresponds to r = -U"/U' being a constant. a change in initial wealth does not affect the willingness to insure (as measured by the risk premium R). Combining these two results with the definition of the risk premium yields U(w+E(a)) + U' E[a-E(a)] +1/2 U" E[a-E(a)]2 U(w+E(a)) .e. it follows that the utility function U() can always be expressed exactly as U() = e. .r + K. the Arrow-Pratt coefficient of absolute risk aversion r = -U'/U' provides all the information about the underlying preference function U().e.e. Then. i. . i.

Ui[w+E(a)-R] = EUi[w+a] implies that Ri = w + E(a) -Ui-1EUi(w+a) or R1-R2 = U2-1EU2(w+a) . .r1. each with utility function U1(w+a) and U2(w+a).r/2 V].R2 () U2-1E(t) . i = 1. From (1). (1) Also. an additive mean-variance analysis can be justified under CARA and normality. and Ri = the risk premium for individual i. this implies that R1 . r1 (w) < (>) r2(w) for all w. Let t = U2(w+a).E. In other words. Then. Note that [U1(U2-1(t))]/t = U1'/U2' = exp[ln(U1'/U2')] = an increasing function of [ln(U1'/U2')]..U2"U1'/(U2')2]/(U1'/U2') = r2 .U1-1EU1(U2-1(t)). * Decreasing (or Increasing) Absolute Risk Aversion: (Pratt) Definition: Risk preferences exhibits decreasing (increasing) absolute risk aversion if R(w. r2 () r1 EU1(U2-1(t)) () U1(U2-1(E(t))).) is a decreasing (increasing) function of w. This implies: r2 () r1 [U1[U2-1(t)]]/t is increasing (decreasing) in t U1(U2-1(t)) is convex (concave) in t.D. Theorem 1: Consider two decision makers facing the terminal wealth (w+a).U1-1EU1(w+a). Thus. . the following statements are equivalent: .Note: The case of CARA preferences under a normal distribution for "a": a ~ N(A. E[ e r (w + a)] = rw 2 (a A ) e [ e ra e 2V ]da 2 V rw 2 (a A + rV ) r V + 2ArV e [ e ]da 2V 2V (a A + rV ) 2 r 2 V 2rA 1 = e rw [ e ] [ ]da e 2 2V 2V = = e rw [ e 2 2 r(rV 2A) ] 2 which is a monotonic increasing function of [A . Let ri = .r/2 V] is the certainty equivalent. [A . or (w+a) = U2-1(t). It follows that maximizing EU() is equivalent to maximizing [A . V) where "a" has mean A and variance V. R1 (w) < (>) R2(w) for all w.Ui"/Ui'. 2.U1-1U1(U2-1(E(t))) = 0 as r2 () r1. ln(U1'/U2')/w = [U1"/U2' . Proof: By definition.r/2 V]. It follows that R1-R2 = U2-1E(t) . By Jensen's inequality. where R = r/2 V is a global measure of the risk premium. Q.

Note: The case of quadratic utility functions: U(x) = α + β x + c/2 x2. they necessarily exhibit increasing absolute risk aversion (IARA). w = non-random initial wealth. Quadratic utility function can provide a second order approximation to any differentiable utility function. Thus they cannot exhibit strictly decreasing absolute risk aversion. Let a = a/E(x) = relative risk.Theorem 2: The following two statements are equivalent: . or decreases with a proportional increase in (w+a). .U"'/U' + (U"/U')2 0. . Definition: A decision maker is said to exhibit increasing. Theorem 3: The following two statements are equivalent: . They can exhibit risk aversion (c <0). with V(a) = V(x) = [E(x)]2V( a). And in the case of departure from risk neutrality. This implies that U"'/U' (U"/U')2 0.E.D. r(w) is an increasing (decreasing) function of w for all w. Note: Examples of utility functions that exhibit DARA: . . 0 < q < 1. or decreasing relative risk aversion if R increases. . . constant. * Relative Risk Aversion : (Pratt) Let x = w + a = terminal wealth. Note: From theorem 2. is constant. Definition: The relative risk premium R is the proportion of terminal wealth x a decision maker is willing to pay to make him/her indifferent between facing the risky terminal wealth x versus receiving [(1 R) E(x)]: EU(x) = U[(1- R)E(x)]. after choosing Ui(w) = U(wi). d 0. Since EU(x) = α + β E(x) + c/2 E(x2) = α + β E(x) +c/2 [(E(x))2 + V(x)]. Proof: Follows directly from theorem 1. Thus. V(x)). But quadratic utility functions exhibit U"' = 0. (2) Note that the following relationship exists between the relative risk premium R and the absolute risk premium R: R = R/E(x). R(w) is an increasing (decreasing) function of w for all w. . and "a" = random return. U(w) = (w + d)q. quadratic utility functions imply that EU(x) = U(E(x). Using the local measure for R derived above. . it follows that U"' 0 under DARA. In the neighborhood of the riskless case. quadratic utility functions can be used to justify a mean-variance analysis. under decreasing absolute risk aversion (DARA). U(w) = ln(w + d). Q. Given U' > 0. d 0. r(w) = -U"/U' is a decreasing function of w. implying that r/w = . r(x) is increasing (decreasing) in x for all x. this suggests that a local measure of the relative risk premium is given by R 1/2 r V( a) where r = -(U"/U') x = the relative risk aversion coefficient. risk neutrality (c = 0) or risk loving behavior (c > 0). it follows that R = R/E(x) -1/2 U"/U' V(x)/E(x) = -1/2 (U"/U') E(x) V( a).

See Pratt. a proportional increase in "a" would generate an increase in the partial relative risk premium R = R/E(a). Note: A DARA utility function can exhibit constant relative risk aversion (CRRA). x = w + a.U”/U’ = 0. private wealth accumulation seems to be a substitute for external insurance. * Preferences with respect to Moments: U(x).e. risk aversion and CRRA always imply DARA. Most people seem to exhibit DARA: the willingness to pay for insurance seems to decrease with private wealth (R/w < 0). A Taylor series expansion of U(x) evaluated at x = E(x) gives U(x) U(E(x)) + i1 1/(i!) iU/xi [x-E(x)]i . under risk aversion (where U’ > 0 and U” < 0). Thus. CRRA implies that (r/w)x U”’x/U’ + (U”/U’)2 x = U”/U’ < 0. x = w+a. Note: CRRA implies that r/x = -U”’x/U’ + (U”/U’)2x . U(x) = -x1- r for r > 1. However. U(x) = x1- r for r < 1 . corresponding to r = 1 . it follows that R = R/E(a) -1/2 (U"/U') V(a)/E(a) = -1/2 (U"/U') E(a) V(). the percentage of wealth spent on insurance increasing with a proportional rise in (w+a). * Partial Relative Risk Aversion: (Menezes and Hanson). Theorem 4: The following two statements are equivalent: . this suggests the following local approximation to the partial relative risk premium: R 1/2 r V(). In the neighborhood of the riskless case. a more than proportional increase in the risk premium R. Arrow has argued in favor of IRRA.. where r = -(U"/U') a = the partial relative risk aversion coefficient. Common hypotheses: . where R is the absolute risk premium defined above.D. there seems to be only weak empirical support for IRRA. In other words. . with V(a) = V()[E(a)]2. Examples of CRRA utility functions: . R increases (decreases) with a proportional increase in "a" for all w . CRRA corresponds to the relative risk aversion coefficient r being a constant. Example: Under increasing partial relative risk aversion (IPRRA). r increases (decreases) with a proportional increase in "a" for all w. U(x) = ln(x). Most people seem to be averse to risk: they have a positive willingness to pay to insure against risk (R > 0). Define the relative risk = a/E(a). R increases (decreases) with a proportional increase in x for all x. Thus. i. R is a measure of the willingness to pay for insurance relative to the expected pay-off E(a). Proof: Follows from theorem 1. Constant Relative Risk Aversion (CRRA): From theorem 3. .E. decreasing relative risk aversion (DRRA) or increasing relative risk aversion (IRRA). Define the partial relative risk premium R = R/E(a). From the local measure of the risk premium R. Q.

R) U(E(x)) -(U/x) R. .. in the investigation of risk behavior). Noting that M1 = 0. a decrease in M 3 implying an increase in down-side risk. M3 = measure of the skewness of x. Note that skewness to the left (M3 < 0) is associated with "down-side risk".. and Mi = E[x-E(x)]i is the i-th central moment of x. It follows that DARA preferences in general imply "downside risk aversion". Define downside risk aversion as corresponding to a positive willingness to pay to avoid down-side risk. . this gives EU(x) U(E(x)) + i1 1/(i!) iU/xi E[x-E(x)]i = U(E(x)) + i1 1/(i!) Ui Mi where Ui = iU/xi. M2 = V(x) is the variance of x. But we have shown that U"' 0 under DARA. . kurtosis. and R3 = -1/6 (U"'/U').. for i = 3. and combining these two results yields R i2 -[1/(i!)] (Ui/U1) Mi = i2 Ri Mi (3) where Ri = -[1/(i!)] (Ui/U1) is a measure of the marginal contribution of the i-th moment of x to the risk premium R. Assuming that the moments exists. . (3) implies that the objective function of a decision maker can always be approximated by [E(x) . Thus. Recall that EU(x) = U(E(x) . This general formulation has several advantages: it does not require a full specification of U(x).i2 Ri Mi]. and R2 = -1/2 U"/U' = r/2. The above result indicates that downside risk aversion corresponds to R 3 < 0 or U"' > 0. Note: Recall that maximizing EU(x) is equivalent to maximizing the certainty equivalent [E(x) .Taking the expectation and assuming that the moments exist. for i = 2. by including skewness.g.. etc. and it allows to go beyond a simple mean-variance analysis (e. where R is the risk premium.. for i = 4. if DARA characterizes the risk preferences of many people. where R is the risk premium.R]. . 2. . i = 1. r being the Arrow-Pratt absolute risk aversion coefficient.. this would imply that most people are also adverse to downside risk... implying that a rise in down-side risk (a decrease in M3) would tend to increase the willingness to pay for risk (as measured by the risk premium R).

- Ncc Risk ManagementUploaded byTvc Teja
- act std5Uploaded byHelen B. Evans
- 1-s2.0-S030504830100055X-mainUploaded byRym Charef
- LSI Project.docxUploaded byadi1486
- ProQuestDocuments 2017-07-13Uploaded byJavier Reaño
- The Risks of Medical Innovation Risk Perception and Assessment in Historical Context (1)Uploaded by1davidlynch
- wrap-up ch6Uploaded bypino
- Uneven Power and the Pursuit of Peace: How Regional Power Transitions Motivate Integration (WPS 150 2007) Mette Eilstrup-Sangiovanni.Uploaded byMinda de Gunzburg Center for European Studies at Harvard University
- UntitledUploaded byeurolex
- … Until the Bell Rings! Perspectives of Agrarian Reform Beneficiaries (ARB) on sugarcane farmingUploaded byGrignion
- Services RecoveryUploaded bygitarghawale
- Sapm Risk ReturnUploaded byDinesh Sathasivam
- Sytch Motion for ModificationUploaded byJennifer Swift
- Can Democratic Innovations Improve the Performance of Representative Governments? An Agent Based Model ApproachUploaded byWe Vincenzo
- 03. Example Risk Register (1).xlsUploaded byMayank Agrawal
- Are You Getting the Full Benefits From Your Advanced Process Control Systems (2005)Uploaded byYang Gul Lee
- Project profit as a measure of its successUploaded bysafka3426
- Sources of Construction Project RiskUploaded byNoel Tagoe
- GeotecUploaded byBerk Demir
- Fear and Risk in AuditUploaded byElena Angelica Ivan
- IOGP_511.pdfUploaded bySerkan Cebecioglu
- 11 Business Studies Notes Ch01 Nature and Purpose of BusinessUploaded byAyush Srivastava
- Introduction BS FinalUploaded bysathravgupta
- SD Approach to Market Risk TradesUploaded byLou Mauro
- EconomicsUploaded byShubham Chauhan
- Bodhi AOM AssignmentUploaded byShadab Anwar
- ERP Implementation in PharmaUploaded bySiddharth Siddhu
- risk assessmentUploaded byapi-281748270
- SOP F.EUploaded byprash0208
- Telkom Dit-keu - Enterprise Management Delivery Audit - 200617Uploaded byKoala

- Introduction to Latin American Civilizations Notes (University of Chicago)Uploaded byVictor Tan
- Characterizing the Nativism and Statistical Learning DebateUploaded byVictor Tan
- Science and God.Uploaded byVictor Tan
- "Has Science Buried God?" - A Discussion with John Lennox at The University of Chicago.Uploaded byVictor Tan
- EALC 26300 - Week 9.2Uploaded byVictor Tan
- DocGo.net Pa Oxford.pdfUploaded byVictor Tan
- InterviewUploaded byVictor Tan
- Rebuttal to Yeo Bee YinUploaded byVictor Tan
- Victor Tan Resume 2016 - Please employ me!.pdfUploaded byVictor Tan
- Chap 10 Intertemporal Choice QBUploaded byVictor Tan
- Examiner Tips for as English Language 9093 1Uploaded byVictor Tan
- PoemsUploaded byVictor Tan
- Marx PointsUploaded byVictor Tan
- Independence of Latin AmericaUploaded byVictor Tan
- Budget SetsUploaded byVictor Tan
- The Independence of Latin AmericaUploaded byVictor Tan
- Academic Streaming Policy PaperUploaded byVictor Tan
- ApprovalSponsorship13 14(1) 0Uploaded byVictor Tan
- Systems for TCSH Events 2011Uploaded byVictor Tan
- Systems for TCSH Events 2011Uploaded byVictor Tan
- MUN HandoutUploaded byVictor Tan