Value at risk minimization

as a model for decision theory

Enrico Giudice

Abstract

Decision making under uncertainty can be modeled in different ways: the tra-
ditional approach is based on the maximization of the expected value of a
utility function. This thesis aims at studying a model based on the minimiza-
tion of value at risk or, in other words, maximizing a constant-α quantile of
the distribution function of payoffs. The model will be applied to a problem
consisting of a decision maker faced with a lottery composed of a mean of n
binary lotteries repeated over a short time period. Finally the generalized case
of a lottery with k outcomes will be discussed.

A thesis presented for the completion of Bachelor’s degree in Economics

Supervisor: Prof. Massimo Marinacci

Bocconi University
Academic year 2016/17
Contents

1 Value at risk 2

2 The preference model 5

2.1 Lotteries . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2.2 The expected utility model . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2.3 The value at risk model . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

2.4 The constant-quantile assumption . . . . . . . . . . . . . . . . . . . . . . . 11

3 An example: mean of n binary lotteries 12

3.1 A closer look at the tail of the distribution . . . . . . . . . . . . . . . . . . 16

3.2 Risk seekers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

3.3 Mean of n lotteries with k outcomes . . . . . . . . . . . . . . . . . . . . . . 21

4 Conclusions 23

1
1 Value at risk

The risk of a wrong decision is

preferable to the terror of indecision.

Maimonides

In the world of finance, groupings of financial investments called portfolios can be

composed of very diverse assets, and subsequently their returns can follow complex distri-
butions. The need to describe the riskiness of the portfolio as a whole is a major problem
in the field. Risk measures are functions that map a set of random variables ∆ that
represent portfolio losses to real numbers. They have the goal of providing a degree of the
objective riskiness of one’s holdings. An obvious (and common) risk measure is standard
deviation: in its case, it gives an intuitive and immediate sense of the volatility of the
portfolio, and can be used as a tool to compare different assets. Value at risk is one of
such risk measures, and is defined in the following way:

Definition 1 (Value at risk) Given a confidence level (1 − α) ∈ (0,1), the value at

risk of a portfolio at α over the time period t is given by the smallest number r such that
the probability of a loss over a time interval t greater than r is α.

In other words, value at risk is defined as a loss that won’t be exceeded with 1 − α
confidence. For example, if an asset has a value at risk of $1000, with α = 0.05 and t = 1
day, it is equivalent to saying that with a 95% confidence level, it will not lose more than
$1000 in one day. Note that value at risk does not give any indication of what the greatest
possible loss might be: it is merely a quantile of the probability distribution of the losses of
the asset. Computing its value is extremely simple as long as the probability distribution of
the asset is known. In the financial world, however, probability distributions of portfolios
are often unknown and require various estimation methods, such as past historical returns,
variance-covariance, or Monte Carlo simulations.

Value at risk is a common tool for measuring the riskiness of an asset firstly because

2
of its simplicity: since it is measured in price units (or as a percentage of portfolio value)
it gives a concise and intuitive sense of the possible losses that one might incur over a
certain time period. It is also widely used by economic agents such as banks or investors to
allocate risk by using it to compare profitability of different portfolios. The risk measure
has recently enjoyed a high reputation, since the Basel II accords of 1999 established value
at risk measures as one of the preferred market exposure metrics across the world.

Value at risk has however some important limitations: notoriously, it is not generally
coherent, since it does not always satisfy the subadditivity condition. In order to fully
understand what this implies, we must first define the property of coherence. The con-
cept is formalized by Artzner et al. (1999), who propose a classification scheme for risk
measures whereby a risk measure is said to be “coherent” if it satisfies four conditions.

Definition 2 (Coherence of a risk measure) Consider two random variables X and

Y viewed as elements of a set of random variables ∆. A coherent risk measure is a
function ρ : ∆ → R such that

ρ(Y ) ≥ ρ(X) if Y ≥ X (Monotonicity)

ρ(λX) = λ ρ(X), ∀λ ≥ 0 (Positive homogeneity)

ρ(X + k) = ρ(X) + k, ∀k ∈ R (Translation invariance)

ρ(X + Y ) ≤ ρ(X) + ρ(Y ) (Subadditivity)

Subadditivity states that in order for a risk measure to be considered coherent, it must
decrease (implying a lower risk) if different assets are pooled together. For example, if
a subadditive risk measure is used to make a financial decision regarding the number of
identically distributed (but uncorrelated) assets to buy, one is encouraged to buy as many
identically distributed assets as he can. This is because the resulting portfolio would have
a lower variance than the single asset while keeping the expected value unchanged (a
practice commonly used by insurance companies called risk pooling).

3
 The fact that value at risk does not generally satisfy subadditivity implies that it does
not always encourage behavior such as risk pooling. Fortunately, there are important
cases in which value at risk is subadditive: in the specific case of normality of returns, it
can be shown to be coherent below the mean. We will prove this result, but a technical
observation must be made beforehand.

Risk measures like value at risk are defined over the space of losses, not gains: in
fact, a lower value at risk implies a minor loss, hence a lower risk. From now on, we will
consider losses as negative values, since we are interested not only in the lower part of the
distributions of returns, but also in analyzing the possible gains of our decision maker. In
other words, we simply want to express value at risk in terms of negative profits instead of
positive losses. Switching the sign of the “loss” variable has no other effect than changing
the sign of value at risk from positive to negative. However, the condition of subadditivity
that we saw above now has an inverted sign, since a lower value at risk now implies a
higher risk. In the long run, this operation will simplify our model, since value at risk
can now be expressed as the α quantile of the distribution function of the returns.

Figure 1: A graphical explanation of value at risk: the area to its left is α.

We can now proceed with proving that value at risk satisfies subadditivity below the
mean, given normally distributed returns. Let X and Y be normally distributed with
mean µi and variance σi2 , with i ∈ {X, Y }. With our new interpretation at hand of value

4
at risk as a quantile of the return distribution function, let us define z1−α as the value
such that P (Z ≤ z1−α ) = 1 − α, where Z is distributed as a standard normal distribution
N (0, 1). We can now express value at risk in terms of µi and σi :

V aR(i) = µi − z1−α σi (1)

Subadditivity holds if the following condition is satisfied:

V aR(X + Y ) ≥ V aR(X) + V aR(Y )

By plugging in equation (1) and using the definition of correlation ρ, the above condition
becomes

q
2
µX + µY − z1−α σX + σY2 + 2 Cov(X, Y ) ≥ µX − z1−α σX + µY − z1−α σY
2
+ σY2 + 2 σX σY ρ(X, Y ) ≤ z1−α σX
2
+ σY2 + 2 σX σY



z1−α σX
z1−α (ρ(X, Y ) − 1) ≤ 0

If z1−α is positive (α < 0.5), the inequality always holds, and value at risk is a subadditive
risk measure. The fact that z1−α > 0 implies from equation (1) that V aR(i) < µ(i):
hence value at risk is subadditive below the mean. On the other hand, if z1−α is negative
(α > 0.5), the inequality is never true, and value at risk is not subadditive.

2 The preference model

In finance, the distributions of portfolio losses are often unknown and are rarely normally
distributed. Because of this, value at risk has been criticized since it is not guaranteed to
be coherent in every distribution. In fact, it has been known at least since Mandelbrot

5
(1963) and Fama (1965) that financial losses are “fat tailed” and it is thus very difficult
to determine whether subadditivity is satisfied or not.

In this thesis we are interested in analyzing a model in which a decision maker mini-
mizes value at risk: in other words, maximizes a quantile of the distribution of returns.
Just like those who work in the field of finance, decision makers often have to act under
conditions of uncertainty, in which the consequences of their actions are not predictable
with confidence. We can imagine that a generic economic agent who has to act under
such conditions could make decisions according to value at risk. Before describing the
model, we will introduce the concept of lotteries and the expected utility approach.

2.1 Lotteries

The type of decision problems that we want to model can be described as follows: a
decision maker has to choose from a set of actions A. The outcomes of these actions are
not predictable with certainty, but our decision maker can make a probabilistic prediction.
If X is the set of all potential outcomes, then the decision maker associates with each
available action a probability distribution over X. We can therefore define a random
variable for every available action that describes the decision maker’s predictions about
the possible outcomes of that action. In what follows we will refer to such random
variables as lotteries. In particular, we will define a binary lottery as a lottery that yields
two potential outcomes with probability p and 1 − p.

2.2 The expected utility model

Before introducing value at risk in our preferences, we will start by describing the standard
expected utility approach. The model, widely used in microeconomic theory, is based on
the hypothesis that a decision maker’s tastes can be represented by a preference relation.
In the case of the lotteries we mentioned above, if S is the set of all lotteries, a preference
is a binary relation over S; it allows us to compare two elements and describe which of

6
the two satisfies a certain property. We can denote a preference relation over S with .
Therefore, given L, L0 ∈ S a decision maker prefers lottery L at least as much as L0 if
L  L0 . We will define this as a weak preference. From this simple definition, two more
definitions follow intuitively:

• If L  L0 and L  L0 both hold, we can say that the decision maker is indifferent
(denoted by the symbol ∼) between lotteries L and L0 .

• If L  L0 holds but L  L0 does not, we can say that the decision maker has a
strong preference for L (denoted by the symbol ).

The expected utility model is based on a set of four axioms, which are of fundamental
importance:

• Completeness The preference  is complete if for every pair L, L0 ∈ S we have

L  L0 or L  L0 .

Completeness ensures that given two lotteries our decision maker either prefers one
or is indifferent between the two.

• Transitivity The preference  is transitive if for every L, L0 , L00 ∈ S, L  L0 and

L0  L00 imply that L  L00 .

Transitivity is a very intuitive requirement that guarantees that the preferences are
consistent.

• Continuity The preference  is continuous if for every L, L0 , L00 ∈ S and L 

L0  L00 there exists a real number p ∈ (0, 1) such that

pL + (1 − p)L00 ∼ L0

Continuity ensures that there are no “jumps” in people’s preferences: if lottery A is

preferred to lottery B, lotteries which are very similar to A will be preferred to B.

7
 • Independence The preference  satisfies independence if for every X, Y , Z ∈ S
and p ∈ (0, 1), we have

X  Y =⇒ pX + (1 − p)Z  pY + (1 − p)Z

Independence states that by comparing pX + (1 − p)Z with pY + (1 − p)Z, the

decision maker should focus on his preference of X over Y , independently of the
values of Z or p. The independence axiom is the more controversial restriction which
is key to expected utility theory.

Given these four axioms, the Von Neumann-Morgenstern expected utility theorem
states that any preference that satisfies these axioms can be represented by a function
U : S → R such that
L  L0 ⇐⇒ E(U (L)) ≥ E(U (L0 )) (2)

This is an important result since it proves that any preference of a rational agent (who
follows the four axioms) can be written as a maximization problem of the expected value
of U . In traditional microeconomics, this theorem is widely used since it provides a link
between the tastes of an individual and the form of the utility function, allowing for
analytical modeling of diverse behaviors.

Given a lottery L, one might ask what is the (certain) amount of money that gives the
same expected utility to the decision maker. This value is called the certain equivalent
(CE) and is implicitly defined as

U (CE(L)) = E(U (L))

The difference between the expected value of a lottery and its certain equivalent is called
the risk premium ρ:

ρ = E(L) − U −1 [E(U (L))]

8
 The risk premium can be defined as the maximum amount the decision maker is willing
to pay to avoid all uncertainty and receive instead the expected value of the lottery. In
other words, is represents the extra cost faced by the agent due to the uncertainty of the
outcomes.

2.3 The value at risk model

In our model, agents will maximize the α quantile of the distribution of returns instead
of the expected value of the U function. We are interested in what the link is between
value at risk-based preferences and the expected utility model.

If we take the U −1 function of each side of inequality (2) (assuming U is monotonic),

and using the definition of certain equivalent (CE), we obtain:

L  L0 ⇐⇒ CE(L) ≥ CE(L0 )

This result is very intuitive: the decision maker’s preference of L to L0 is equivalent

to saying that the guaranteed return that yields the same utility of L is greater than
that of L0 . We are now ready to introduce value at risk to this model. As we have
seen before, the risk measure depends on three parameters: a real number α, a time
period t, and a probability distribution function. The time period is of great relevance
in problems of financial risk allocation since future returns are discounted. In order to
adapt this measure to the one-period model used in standard expected utility theory
we will consider all outcomes to be immediately effective. From now on, we will ignore
future time periods and consider that all actions happen in a near enough future that
the decision maker considers them immediate. Firstly, we will write equivalence (2) in
terms of value at risk. Let X be a generic simple lottery with a probability distribution
f (x) and cumulative probability distribution F (x). By its definition as a quantile of the

9
probability distribution function of X, we can define value at risk in the following way:

V aR(X, α) = F −1 (α) (3)

If we take the first derivative of the value at risk function in α

d V aR(X, α) 1
= −1
dα f [F (α)]
we can easily see that V aR(X, α) is increasing in α, since f (x) is a probability density
function and therefore positive for every x. We can conclude that for any random variable
X there must be a confidence level αX such that V aR(X, αX ) = CE(X). We can now
write condition (2) as

L  L0 ⇐⇒ V aR(L, αL ) ≥ V aR(L0 , αL0 )

A couple of remarks should be made at this point. Firstly, we have not yet made
any additional assumptions on the expected utility model, since we have merely written
our decision maker’s preferences as a function of value at risk. Secondly, we have found a
simple answer to an obvious question: if the decision maker bases preferences according to
the α quantile, what confidence level 1 − α will he choose? In order to provide a link with
expected utility theory, the choices of the decision maker will be at a confidence level such
that V aR(X, αX ) = CE(X). Lastly, we can give a new interpretation to the parameter
αX : we can define it as the maximum probability our decision maker can tolerate that
his profit will be negative by participating in lottery X. To see this, we can start from
the implicit definition of CE:

U [CE(X)] = E[U (X)]

10
By using the properties of the expected value, we obtain

E[U (X) − U (CE(X))] = 0

In expectations, the utility of the lottery decreased by the utility of winning CE is zero.
It is clear that we can interpret CE(X) (or V aR(X, αX )) as the maximum price that the
decision maker is willing to pay to participate in the lottery X, given no other profitable
alternative. Using definition (3) we can write αX as

αX = F [CE(X)] (4)

The parameter αX is therefore the probability that X ≤ CE(X), namely the probabil-
ity that the decision maker’s profit turns out negative if he pays CE(X) for X. But since
we have seen that CE is the maximum he is willing to pay for it, we can interpret αX as
the maximum probability he can tolerate that his profit will be negative by participating
in lottery X (given no other profitable alternative).

2.4 The constant-quantile assumption

Keeping this interpretation of αX in mind, we can make a key assumption in our model,
which will not only allow us to simplify and bring more tangible results than the expected
utility model, but will also provide the main difference in terms of behavior. We will
assume that for every lottery X, αX is a constant. This means that the area under the
probability distribution function to the left of the certain equivalent is a constant in each
individual. The usefulness of the assumption is very apparent: an individual’s behavior
can now be described by a single parameter α, which tells us not only his degree of risk
aversion, but also the exact monetary value that that lottery has for him. Finally, using
the interpretation of α that we developed in the last subsection, we can interpret this
assumption in another way. For every degree of risk aversion, there is a fixed threshold
of probability that one can tolerate that his profit will turn out negative (given no other

11
profitable alternative), regardless of the probability distribution of the lottery that one
faces.

This is without doubt a rather strong assumption: in real life situations, we can
imagine that one’s threshold depends on the severity of the possible losses and the wealth
that one holds at the moment of the decision. In fact, we can imagine cases in which
particular changes to the lower tail of the probability distribution could have no effect
on the agent’s preferences (an example of this is given by Figure 2). The fact that
the severity of the losses could in some cases have no influence on the decision maker’s
behavior might sound like an extreme simplification. This argument is true, but only
arises when the shape of the distribution function is severely altered. In the case of
“well-behaved” distribution functions (such as bell-shaped distributions) the constant-
α assumption merely states that the threshold remains fixed as the parameters of the
function are changed. We can conclude that this assumption will bring valid results only
when the model is used to compare lotteries of the same family of distribution functions
(such as normal, t-student etc.).

3 An example: mean of n binary lotteries

We will now apply our constant-α model to a problem. Consider a simple lottery L that
yields two monetary outcomes, x1 and x2 , with a probability p and a probability (1 − p)
respectively. The lottery is repeated over a short time horizon n times, and at the end
the resulting profit is divided by n before being rewarded to the decision maker. We will
call the resulting lottery Ln .

Pn
n i=1 Li
L =
n

12
Figure 2: In this extreme case, the decision maker values both lotteries the same amount,
regardless of the fact that the bottom one is objectively less profitable.

In order to determine the distribution function of payoffs, let us first compute the expected
value of the resulting lottery:

 Pn 
n i=1 Li
E(L ) = E = E(L) = px1 + (1 − p)x2
n

Independently of the value of n, the expected value will be the same, while the variance
will decrease as n increases. This should be a strong incentive for risk-averse agents to
value Ln more, as the risk (variance) decreases ceteris paribus. The fact that the variance
of Ln decreases with n can be easily shown:

13
 Pn 
n i=1 Li
Var(L ) = Var
n
n
1 X
= Var(Li )
n2 i=1
1h 2 i
= (px1 + (1 − p)x22 ) − (px1 + (1 − p)x2 )2
n
p(1 − p)(x1 − x2 )2
=
n

In order to understand how the returns are distributed, consider X, the binary lottery
in which x1 = 1 and x2 = 0. X is thus distributed as a discrete Bernoulli random variable,
and the sum of n identical and independent binary lotteries Xi is a binomial(n, p) random
variable. Using the central limit theorem we can state that
Pn
Xi − np p̂ − p d
pi=1 =q →
− N (0, 1)
np(1 − p) p(1−p)
n

Pn  
p(1−p)
where p̂ is the sample proportion i=1 Xi /n, which is distributed as N ∼ p, n

for large enough n. The quality of the approximation of a binomial distribution with a
normal function gets better for large number of Bernoulli trials n and p close to 0.5. In
this thesis, we will use a common rule of thumb, which states that the product between
the probability of the least probable outcome and n is larger than five:


 np > 5
(5)
 n(1 − p) > 5

The approximate continuous distribution of Ln is the linear transformation of p̂

p(1 − p)(x1 − x2 )2
 
p̂x1 + (1 − p̂)x2 ∼ N px1 + (1 − p)x2 ,
n

We have thus shown how the returns of Ln are (approximately) normally distributed.
We can now apply our model, since we have shown how value at risk is a coherent risk

14
measure below the mean. We shall impose the assumption we introduced in Section 2.4:
let us assume that αLn is a constant, in the sense that it does not depend on the parameters
p, n, x1 or x2 , but solely on the inherent risk aversion of each decision maker. For
simplicity’s sake, we shall call this constant α from now on. We are now in a position
to compute the certainty equivalent CE that our agent assigns to this experiment. We
will initially assume that the agent is risk-averse. Using the implicit definition (4) we can
determine CE as the payoff such that

Pr(Ln − CE < 0) = α

We want to write CE as a function of the variables that determine the distribution of

the payoffs: we can do this using definition (1) of value at risk, keeping in mind that it
coincides with the certain equivalent (as we have seen in Section 2.3):

CE = µLn − z1−α σLn

r
p(1 − p)
= px1 + (1 − p)x2 − z1−α |x1 − x2 | (6)
n

It is easy to see that the certain equivalent increases with n. This is rather intuitive: if
the mean is taken of a lottery that is repeated more times, the chance of extreme payoffs
becomes smaller: this decreases the riskiness of the gamble and the risk-averse decision
maker will thus value more the lottery. Note that, for n → ∞, CE → E(Ln ): since the
variance of Ln tends to zero, the certainty equivalent tends to the true expected value of
the lottery, and the individual exhibits risk neutral behavior (Figure 3).

Expression (6) is very convenient since it can be divided into expected value and risk
premium ρ (which coincides with the standard deviation of Ln ). The risk premium is thus
obtained by subtracting CE from the expected value:
r
p(1 − p)
ρ = z1−α |x1 − x2 | (7)
n

15
 E(L)

CE

Figure 3: The certainty equivalent CE (blue line) tends asymptotically to E(L) as n

increases. This plot corresponds to the case E(L) = 2.

It is easy to show that a mean-preserving spread will decrease the CE, as the expected
value will not change while |x1 − x2 | increases. Let us now consider what happens if the
higher of the two payoffs increases.

3.1 A closer look at the tail of the distribution

Let x1 > x2 . To see what happens to the certain equivalent due to an increase of x1 , let
us take the first derivative:

r
dCE p(1 − p)
= p − z1−α (8)
dx1 n

Obviously, the expression does not have a clear sign: this is due to two contrasting
effects produced by the increase of x1 : on one hand, it raises the expected value of
the lottery, increasing the agent’s willingness to pay and thus the CE. On the other
hand, it will increase the variance of Ln , and consequently the uncertainty of the lottery,

16
decreasing the CE (since we are assuming the agent to be risk averse). However, the first
2
effect normally prevails over the second one: the derivative is negative if z1−α (1 − p) > np,
2
but since we are under hypothesis (5), np is greater than 5. How likely is it that z1−α (1−p)
is greater than 5? In the case where p = 0.5, α would have to have a value of around
0.0008 or less in order for (8) to be negative. An individual with a value at risk confidence
level of 99.92% is extremely risk averse: he would not accept the risk of a loss if it were
more than 0.08%. This interpretation is not precisely correct, as we will see in the next
paragraph. Nevertheless, this means that for individuals that are not extremely risk
averse, an increase of x1 will intuitively increase their willingness to pay, as they will
value the lottery more.

But what does “extremely” risk averse mean? To understand this, let’s see what
happens to the CE when (8) is equal to zero:

r
dCE np
= 0 ⇐⇒ z1−α = (9)
dx1 1−p

Inserting this expression in definition (6) of certain equivalent we obtain:

r
p(1 − p)
r
np
CE = px1 + (1 − p)x2 − |x1 − x2 |
1−p n
= px1 + (1 − p)x2 − p(x1 − x2 )
= x2

The individual is so risk averse that he is not willing to pay more than the lowest
payoff: but by paying the price of the lowest possible outcome for Ln , isn’t he ensuring
himself against any possible loss? Why did we previously conclude that there is a 0.08%
chance of a loss?

The answer is, of course, that the normal distribution is an approximation of the
underlying discrete distribution of payoffs. While the approximation is generally good
given assumption (5), around the tails of the distribution the error becomes very apparent.

17
 The continuous approximation of the distribution of Ln has many obvious virtues: it’s
very simple to use and provides a continuum of preferences. The (true) discrete distribu-
tion has the flaw of being discontinuous: if we were to consider the discrete distribution,
the certain equivalent could only have a value of one of the (n + 1) possible outcomes of
Ln . In addition to this, binomial distributions are much harder to work with than normal
ones.

We can however use the discrete distribution to find the critical value of α that defines
this “extremely risk averse” behavior: it is easy to show that the probability of outcome
x2 is (1 − p)n . This is thus the exact level of α that defines the “extremely” risk averse
individual, since his willingness to pay coincides with the lowest possible payoff. Notice
that it does not depend on the outcomes of the lottery, but only on parameters p and
n: the behavior of the agent is consistent in the sense that its extreme behavior will
not respond to changes in the payoffs. Therefore, an “extremely” risk averse agent will
keep his extreme behavior regardless of how the values of the outcomes change. In this
case, any individual who has a confidence level higher than 1 − (1 − p)n will simply
never enter the lottery, since the discrete distribution is defined over (x2 , x1 ). Notice
that since normal distributions are defined over all R, in the continuous case the same
individual will refuse to pay more than his CE, which will have a value lower than x2 .
This behavior would be completely irrational and should not be contemplated, since it
is caused merely by the inadequacy of the continuous approximation. Therefore, we will
consider the discrete threshold value of α when referring to extremely averse individuals:
in their case, the certain equivalent coincides with the lowest of the two payoffs. We can
see how the advantage of continuous preferences appears to be lost when we examine the
tails of the distribution too closely: we can however look at what happens to the absolute
error between the continuous critical value of α and the discrete one as n increases. While
we have seen that the discrete (exact) critical α is (1−p)n , we can compute the continuous

18
one by solving equation (9) for α:

r 
np
α=1−Φ
1−p
where Φ is the cumulative distribution function of the standard normal probability dis-
tribution. The absolute error  is thus

 r  
 n np 
 = (1 − p) + Φ − 1
1−p

It is clear that the limn→∞ () is zero: predictably, as n increases, the continuous ap-
proximation improves its precision, even at the extreme tails of the distribution. There-
fore, the α value of 0.08% that we encountered before (for n = 10) will tend to zero if the
lottery were repeated more times.

3.2 Risk seekers

So far we have analyzed the behavior only of risk-averse agents: it is intuitive that less
uncertainty has a positive effect on the value that an agent associates with a lottery.
Indeed, empirical evidence shows that people are generally risk-averse. Risk seeking is a
less usual behavior: in this case, an individual would value more a lottery with a greater
variance than a lottery with a lower variance, for equal expected value. We can model
this kind of behavior in a very similar way as before: in this case however, the CE will
be larger than the expected value of Ln : this is because the risk premium is negative.
Indeed, the risk premium now denotes the extra amount the agent is willing to pay in
order to participate in the lottery because of its riskiness. Since in our model the risk
premium coincides with the standard deviation, the higher the variance (riskiness) of the
lottery he is facing, the higher the risk premium will be.

A risk seeker is described in our model as an individual who has a confidence level
(1−α) smaller than 0.5. To see this, is it clear that in the case where α = 0.5 the individual

19
is risk neutral: z1−α is equal to zero and the risk premium is zero. If ρ = 0, the certain
equivalent coincides with the expected value and the individual is thus risk neutral. If α
is greater than 0.5, z1−α will be negative and the formula for the risk premium (7) will
be negative as well. The individual is thus willing to pay extra to participate in a more
risky lottery, hence exhibiting a risk seeking behavior.

Risk-seeking behavior is well accommodated by our model: all expressions for CE, ρ
and his preferences remain unchanged. The only difference with risk aversion resides in
the possible values of α, summarized in the following table (let p be the probability of the
highest payoff):

V alues of α Behavior
(0, (1 − p)n ] Extremely risk averse
(1 − p)n , 12


Risk averse
1
2
Risk neutral
1 n


2
,1 −p Risk seeking
[1 − pn , 1) Extremely risk seeking

For α = 0, the individual is infinitely risk averse and will not participate in any gamble
regardless of the odds or the payoffs.

Using the definition of α as the maximum probability a decision maker can tolerate
that his profit will be negative, we can give an alternative interpretation of a risk seeker.
In fact, we can conclude that a risk seeker can be defined in our model as an individual
who can tolerate that his final profit will be negative with a probability exceeding 21 . Risk
averse individuals, of course, have a lower tolerance threshold, as their values of α cannot
exceed 21 .

An interesting remark can be made at this point. In Section 1, we noted how value
at risk has a subadditivity problem, as it generally does not encourage diversification;
however, we also noted that value at risk is subadditive below the mean in normal dis-
tributions. We avoided this problem by considering risk-averse individuals, for which the

20
certain equivalent (which as we have previously seen can be interpreted as value at risk)
was less than the expected value of the lottery. With risk-seekers, value at risk becomes
a non-coherent risk measure, as we are now considering values higher than the mean
(since α is now greater than 0.5). What does the violation of subadditivity imply for
our preferences? Recall the definition of subadditivity: a risk measure ρ is subadditive if
ρ(X + Y ) ≤ ρ(X) + ρ(Y ) holds. That is, the risk measure indicates that it is preferable
(less risky) to pool two assets together than to hold them separately. In a way, this is
a requirement for risk-averse behavior. In fact, if an individual would make his choices
according to a risk measure that violated subadditivity, he would choose to keep two
assets separated instead of pooling them together and decreasing his variance: a typical
risk-seeking behavior. His behavior is not coherent under a strictly financial point of view,
but from an economic point of view, it is perfectly coherent with a risk seeker’s prefer-
ences. In the case of normal returns, value at risk works surprisingly well as a preference
measure, since it accommodates both risk averse and risk seeking preferences.

3.3 Mean of n lotteries with k outcomes

Next we generalize the result to the case of a lottery with k outcomes, rather than the
binary lottery L we have considered so far. Let Lk be a lottery with k different outcomes
xi , with i ∈ {1, 2, 3, ...k}. Each outcome has a probability pi to occur. As before, the
lottery is repeated over a short time horizon n times, and at the end the resulting profit
is divided by n before being rewarded to the decision maker. We will call the resulting
lottery Lk,n .

Since the central limit theorem states that the sum of identical independent random
variables tends towards a normal distribution, we can conclude that just as in the case
of binary lotteries, we can determine a (true) underlying discrete distribution and an
approximate normal distribution. As usual, we will focus on the continuous distribution
for practical purposes. Once we compute the expected value and variance of Lk,n we will
have all the necessary parameters to determine the formulas we are interested in. The

21
expected value is thus
 Pn
Lki

k,n i=1
E(L ) = E
n
k
= E(L )
Xk
= p i xi
i=1

While the variance of Lk,n is:

Pn
Lki

k,n i=1
Var(L ) = Var
n
n
1 X
= Var(Lki )
n2 i=1
 !2 
k k
1 X X
= pi x2i − p i xi 
n i=1 i=1
" k k k−1 X k
!#
1 X 2 X X
= p i xi − p2i x2i + 2 p i p j xi xj
n i=1 i=1 i=1 j=i+1
k k−1 X k
!
1 X 2 X
= x pi (1 − pi ) − 2 p i p j xi xj
n i=1 i i=1 j=i+1

From the continuous approximate distribution of Lk,n , we can calculate the risk pre-
mium ρ in the usual way

k k−1 X
k
! 12
p z1−α X X
ρ = z1−α Var(Lk,n ) = √ x2i pi (1 − pi ) − 2 p i p j xi xj
n i=1 i=1 j=i+1

Note that, for k = 2, the result is the same as (7). All the properties we have seen so
far obviously hold in the generalized case, including the “extreme risk aversion” and risk
seeking behavior. However, the adequacy of the approximation depends on many more
parameters and is more difficult to determine than in the binary case.

22
 The equation of the certain equivalent can be easily obtained as the difference between
the expected value and the risk premium:

k k k−1 X
k
! 21
X z1−α X X
CE = E(Lk ) − ρ = p i xi − √ x2i pi (1 − pi ) − 2 p i p j xi xj (10)
i=1
n i=1 i=1 j=i+1

4 Conclusions

In this thesis a preference model based on the maximization of a given α-quantile has
been explored. It has been demonstrated here how this corresponds to the minimization
of value at risk, a risk measure commonly used in the world of finance. We have analyzed
in particular the problem of a mean of n binary lotteries, and its normally distributed
approximation. We have also seen how the model can encompass a range of very diverse
behaviors, from the “extremely risk averse” to the risk seekers. The model differs from
the expected utility model only by the “constant-quantile” assumption that we discussed
in Section 2.4. Although a simple assumption, it is without doubt powerful, as it allows
us to make accurate predictions about an agent’s behavior based on a single parameter.
A way to avoid the problem of oversimplification would be to assume that the value of α
is not a constant but a function of the distribution of payoffs. In this case, it would be
possibile to determine a tie between the function that determines α and a hypothetical
utility function.

The main advantage of this model is its simplicity: even though a strong enough as-
sumption will always lead to simple results, it appears that in this case the outcomes leave
a sufficient degree of flexibility and the model could thus potentially have a wide range
of applications. For instance, the fact that a generic agent’s behavior can be integrated
in one measure of probability makes modeling populations an easy task. Indeed, we can
imagine that the values of α could be distributed among a population with a certain
probability distribution. It can be noted that there are other models that have the advan-

23
tage of using a single parameter, but lack the versatility of the constant-quantile model.
For example, the CRRA (isoelastic) utility function differentiates different degrees of risk
aversion through a single parameter, but does not contemplate the possibility of risk seek-
ers as this model does. As one can see, in the inevitable tradeoff between complexity and
applicability, the value at risk-based model fares well, since it is based upon a hypothesis
that is very clear and manages to bring relevant results. In fact, from a theoretical point
of view, value at risk shows itself to be a very convenient risk measure since (in the case
of normally distributed returns) subadditivity does not pose a problem as long as the
investor is risk averse. In practice however, this is not always applicable to many real-life
financial decisions since portfolio returns often don’t follow normal distributions.

In this work the model has been applied to just one problem: even though the model
could potentially be applied to any form of function (including t-student distributions),
as mentioned in Section 3.1, discrete returns will bring more broad results. This is be-
cause the functions for certain equivalent and risk premium become discrete functions
themselves. In fact, the equations for risk premium and certain equivalent can only have
values that coincide with the outcomes of the lottery, by the definition of a quantile. Be-
cause of this, paradoxically the less possible outcomes the lottery has, the more imprecise
the results of the model will be. Continuous distributions therefore work very well, since
the continuum of outcomes provides the individual with the exact value such that his
probability of a loss is exactly α. A solution to the problem of imprecise results when
considering simple lotteries would be to always consider a continuous approximation of
the underlying true distribution of payoffs when computing the value that the decision
maker attributes to the lottery. In this case however, the results would be largely de-
pendent on the adequacy of the approximation. We can conclude that the model has
indeed several limitations; nevertheless, it can provide us in many cases with interesting
yet straighforward results and a simulation of the behavior of an individual who faces
decisions under uncertainty.

24
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