tr

Risk Attitudes

r5: his chapter marks the beginning of our in<iepth study of preferences.
-L Before rve begin, let us revierv where rve have been and think about rvhere
lve are going. The frrst six chapters provided an introduction to the process of
structuring decision problems for decision analysis and an overview of the role
that probability and utiliry theorv play in making choices. Chapters 7 through 12
have focused on probability concerns: using probability in a rariety of ways to
model uncertainry in decision problems, including the modeling of informarion
sources in value-of-information problems.
At this point, we change directions and look at the preference side of deci-
sion analysis. How can we model a decision maker's preferences? This chapter
looks at the problems associated with risk and return tradeoffs. Chapter 14
briefly explores the axiomatic foundations of utility theory and discusses certain
paradoxes from cognitive psychology. These paradoxes generally indicate that
people do not make choices that are perfectly consistent with the axioms, even
though they may agree that the axioms are reasonable! Although such inconsis-
tencies generally do not have serious implications for most decisions, there are
certain occasions when they can cause difEculty.
The primary motivating example for rhis chapter comes from the history of
railrvays in the United States. Imagine whar rvas going through E. H. Harriman's
mind as he considered his strateg-y for acquiring the Northern Pacific Railroad
in March I901.

E. H. HARR'MAN F'GHTS FOR THE NORTHERN PACIFIC RAILROAD

"FIow could they do it?" E. H. Harriman asked, still angry over the fact that
James Hill andJ. P. Morgan had bought the Burlington Railroad out from uncler
his nose. "Every U.S. industrialist knows I control the railroads in the West.

363

RdarrJ( (rttz)
 t'.
l.r4 CHAPTER I3 RISK ATTITUDES

I have thc Illinois Central, the Union Pacific, the Central and Southern pacific,
not t() tncntion thc Oregon Railroad and Navigation Companr,. Isn't
that true?,.
"\'cs, sir'," re plicd his assistant.
"\4/cll, rve x'ill put the prcssure on Messrs. Hill and
Morgan. They rvill be sur-
priscd indeed to find out tltat I ltave acquired a controlling-interest in their orvn
railroad, the Northcrn Pacific. I may even be able to persuade them to let
me
ha'e the Brrrlington. By the way, horv are thc stc:k ptrrcrrases going?"
"Sir, wc have completed all of the purchases ttrat
you so far. you
may lrave noticed that our transactions have driven rhe price "r.rthorized
of Northern pacific
stock up to more than $100 per share.,'
Ilarriman cot'tsidered this information. If he bought too f;asr, he could force
the stock price up high enough and fast enough rhar Hitt might begin
ro suspecr
that Harriman was uP to something. Of courie, if Harri*ai .o,,li acquire the
shares quickly enough, rhere would be no problem. on the other hand, if
he
bought the shares slorvly, he would pay lower prices, and Hill might not norice
the acquisition until it rtas too late. His assistant's information,-horvever, sug-
gested that his situation was somewhat risky. If Harriman's plan were discovered,
Hill could persuade Morgan to purchase enough arlditional Northern pacific
shares to enable them to retain control. In that case, Harriman would have
paid
premium prices for the stock for nothing! On the other hand, if Hill did not
make the discovery immediately, the triumph would be that much sweerer.
'FIow many more shares do we need to have control?" asked Harriman.
'If you could purchase another 40,000 shares, sir, you would own 51 percent
-
of the company."
Another 40,000 shares. Harriman thought about giving Hill and Morgan or-
ders on how to run their own railroad. Horv enjoyable that would be! yes, he
rvould gladly increase his investment by that much.
'Of course," his assistant continued, 'if we try to purchase these shares im-
mediately, the pricc will rise very quickly. you wilr probably ehd up pa)rrng an ad-
ditional $15 per share above what you would pry ir rve were to proceed more
slorvly.'
'well, $600,000 is a lot of mone1,, and I certainly would not wanr ro pay
more. Bt't it would be worth the money to be sure that we lr,ould be able to
rvatch Hill and Morgan squirm! Send a telegram to my broker in New York right
alvay to place the order. And be quick! It's already Friday. [f rve are going to do
this, rve treed to do it today. I don't rvant Hill ro have the chance to think about
this over the weekend.'

R.ISK
Basing decisions on exPected values (EMvs) is convenient, but it can lead to
decisions that may not seem intuitively appealing. For example, consider the fol-
lowing two 8ames. Imagine that you trave ttre opportunity io play one garne or
the othcr, but only one time. Which one would ytu prefer to ptayl youi choice
also is drawn in decision-rree form in Figure 13.i.
 365
RISK

Game I Win $30 with Probabiliry 0'5'

t-ose $1 with ProbabilicY 0'5'

Game 2 Win $2000 rr'ith probabilin'0'5'

Lose $i900 rvith Probabilin'0'5'

Garnelirasanexpectcdvaltteof$14'50'Game2'orttheotherhand'hasan
your choice on the basis of ex-
cxpccted valtre of ssd.oo. If you were ro make
Most of us' horvever' would con-
pectcd value , then 1'ou *ot'li choose Game 2'
itseems reasonable to suspect that
sider Game 2 to be riskier than Game 1, and
most peoPle actually would prefer Game I'
means that the decision maker is
Usir-rg .*p..,.i values io make decisions
If rve take a long-run frequency
considering only the average or exPected payoff.
rve would be likely to rvin
approach, the exfect d .'a"lue is the average amount
the range of possible values' After
over many plays of the game. But this ignoies
rr'e cotrld at in Game 1 is to lose $10'
all, if r*e play each game l0 times, the w"orst
Ontheotherhand,theworstwecoulddoinGame2isloseSl9'000!
Marryoftheexamplesandproblemsthatrvehaveconsideredsofarhave
value (Eltfv) ' EMV' however' does
been analyzed in terms of expecied monetar' example
the Texaco-Pennzoil
nor caprure risk attitudes. For example, coniider
in chapter 4 (pages 65{9). r Hujn Liedtke y..^.
rfr"id of the prosPect that
pennzoil could .ia ,-rp with nothi.ig .t the end of the court case' he
might be
the Eagle Airlines
rviling ro rake the g2 Uittio' that Teiaco offered' To considera much riskier alter-
the airplane is
case (chapter 5, pages 113-114), purchasing
were sensitive to risk' he
native than leavirig it . money in tt e bank. I1Carothers
someone like E' H' Harriman
might prefer to l.Iue the money in the bank. Even
he found himself' [n our
considered the riskiness of the situations in which
alternative (immediately pur-
example, Harriman weighed the value of a riskless
gain tontrol) against the risky
chasing the 40,000 shaies that were required to

Expected Value (S)

30

-1 900

FIGURE 13.t Two Lottzry C'omes

Which game would You choose?
i

!,66 CHAPTER I3 RISK ATTITUDES

alternative of not purchasing the shares and the possible outcomes t6at mig6t
then follow. Evctr tlrough all of the dollar anr()urlrs were not specified, it is clear
that Harriman \{as not thinking in [ernts of EM\/.
Individualswho are afraid of risk or are sensitive [o risk are called risk-aua-se.
We can explain risk aversion if we think in rerms of a utitits-
lunction (Figure 13.2)
that is curved and opening downward (the tcchnical term for .u.*," wit6 this
shape is "concave"). This utility functio. represents z r'ay, to "tra.slate dollars
irlto "utilicy units." That is, if rve take some dollar atnounr (x), we can locare rhal
amounI on the horizontal axis. Read up to the iune and then horizontally
across to the vertical axis. From that point \ve carl read off the utilicyvalue U(.r-)
for the dollars we started with.
A utility function might be specified in terms of a graph, as in Figure i 3.2,
or given as a table, as in Table 13.1. A third form is a mathematical expiession. If
graphed, for example, all of the following expressions would have the same gen-
eral concave shape (opening downward) as the utility function graphed in hig-
ure 13.2:
U(x) = log(x)
U(x)=L-e-x/R
U(x) = af* (or U(x) = ;o.s;.
Of course, the utility and dollar values in Thble l3.l also could be graphed, as
could the functional forms shown abo..,e. Likewise, the graph in Figure i3.2
could be converted into a table of values. The point is that the utiliry funcrion
makes the translation from dollars to utiliq, regardless of its displayed form.

Utility

u(x)

Wealth

FIGURE 13.2 A Utihty Function that Dkptays Rkk Avrsion

 RISK ATTITUDES
367

Utilitl
\\'caltli \/aluc

2i()() ) 7()
'l i(x) l2,r
.j()(x) () !]3
(i()(l (l (r5

I ()() () 1;
0 () )7

TABLE l3.l A Utiltty

l:uttcliott irt 'l abular I:ot rrt

O RISK ATTITUDES
\{'e think of a rypical utiliq,curve as (l) uprr,ard sloping and (2) concave (the
curve opens dou'nrr'ard). An uprtard sloping utility curve makes fine sense; it
means that tnore rtealth is better than less s'ealth, everything else being equal.
Ferr' people will argue rtith this. Concavitt' in a utility crlrve implies that an indi-
vidual is risk-averse.
Imagine that you are forced to play the follor.r'ing game:
\Alin $500 rvith probabiliry 0.5.
Lose 5500 u,ith pr6bability 0.5. -

llbuld ),ou pay to ger our of this situation? Horr' much? The game has a zero ex-
Pectell ralue, so if you rtould pat' something to get our, you are avoiding a risky
situation *i4, zero expected rzlue. Generally,,lf you \oplq trade a ble for a
sute a!qogg1|-Ulr! is less than the expected ralue oFThe
ge: Purchasing insurance is an example of risk-averse behavior. lnsurance
companies analyze a lot of dau in order to understand the probabiliry distribu-
tions associated rvith clainrs for different kinds of policies. Of course, this rvork is
costly. To make up these costs and still have an expecr.ed profit, an insurance
company must charge more for its insurance policy, than the policy can be ex-
pected to produce in claims. Thus, unless vou havr: some reason to believe that
)'ou are more likely than otl-rers in your riskgroup to make a claim, you probablv
are paying more itr insurance premiums than the expected amount you rvould
claim.
Not everyone displal's risk-averse behavior all the Lime, and so utility curves
need not be concave. A convex (opening uprvard) uriliry curve indicates risk-
seeking behavior (Figure 13.3). The risk seeker might be eager ro enter into
a gamble; for example, he or she might pa), ro pla1, the game just described.
An individual who plays a state lottery exhibits risk*eeking behavior. State lot-
tery tickets typically cost $1.00 and have ah expected value of approximately
50 cents.
 ---+

CHAPTER I3 RISK ATTITUDES

Flisk;Seeking

Risk-Averse

Wealth

FIGURE I3.3 Three Diffaent Shapesfor {ltility Functions

Finallll an individual can be risk-neutral.

ity'cu^'e that is ri*ply a straight riae,.forl{rt, Risk neubariry is reflected by a udr-
rhe same as maximizirrg.*pJ.teJ
.r"; oip.rro.,, maximizing EMv is
utility. rrri, ,ri"t., sense; someone
neutral does not care about risk who is risk_
andcan ig.ro;"-.i; aspects of
the alternadves
;T:,tr'.I"'i:1ff:i ,HJ:;.EH
is a nne ror ciroosing
'i"'io., ;;;
arterna-
AJthough most of us are not
risk-neuffar, it often is reasonable
maker ro assume rhat his or her for a,Jecision
ufriry:y:"i;;&
lar amounrs for a particurar decision. finear in the ranse of dol-
This i, .rp".i'"uy true for largeiorpora-
tions that make invorving amounts thai are
assets. In many lllisio.ns small relative to their total
cases, it may be iorthwhile
and then check ro see wheihe-rr. to ule Elvfl/ i., , n.rt*,rf analysis,
J..r'ri""';;;;. io-.i".,g",
o:: ro be fairry sensitive (that is, if the i.
risk attitude. If the decisior, ,,rrrrl sensitive
cision would .n1rt.,for a srighrly de_
.r''rrigh,ry risk-seeking perscn),
decision maker *"y *i*J,olrb"u::.
3:1ff consider modeiing his or her
riit'rttituae
This discussion makes it sound.
as^ though individuars
their utiliq'functions, and rhose can be reduced to
,r,iriq,functiJns ."n ,.r"rr whether
ual is risk-a'erse or risk-se-eti"g. the individ_
K*p
is only a model of an individ,iair-rititra.
in mind, r,o*"*., that the utiriry funcdon
menr of utiliq' funcdons in rowa.d ;sk. lvloreover, oui develop_
this chapter is intended ,o n.tp
risk attitudes a[ a fundament"f with the ,noa"rirrg or
f.u.i, and our model *"r rro, be
certain complicated psychological able
aspects. For example, some -."p,rr."
irai"ilrrrs may
be extemely frightened by
crease their enjoT::, in "!n.
o,rrl;ilff1t1X, ,r.,"u wagers greatry in_
watching.a sporting event, tor
may find that waiting for the exampre. still orhers
,rrr...Lirr,y ,o u.?.roru.i
and exhitaradon, arrhough.";.;;;;;;;; t-ilf;ll.yis ai,source of excitement
For some peopre, nsriG ror... orrn*i.ry.
what ,r,.iir..ir"gis are"
"";;ly tourard risky arter_
tT:::Hl3;,ftTf;:lllf;:llf m,:$,.1lllX:;;":Hilt"lshke,
 REVISITED
369
INVESTING IN THE STOCK MARKET.

le INVESTINGINTHESTOCKMARKET'REVISITED
IIrr.clrar,cautility[urrctiotttlrattranslatcs[i.omdollarsl-out,ilir}',lr<rwslrouldrr,e
trsc iti' Tltc rt'hole idca qt a utility fttnctiotr is thdt it should help to choose
fror-n
expecterl
atn()11g alte rnativcs that have
t,nc"rtait' payoffs' Instlad.3f maximiz'ing
tree or
t,c dccision ,nakerlshortlci n''axinii'e cxpected^utiliqL In a decision
b}' the
'alrrc,
infltre ncc-diagram paYoff talrl<:, thc
uct dollar payoffs rvould be replacecl
corl.csPot}dirrgutilitl.r.alttcsartcltlrcarrall,sispcrfo.rmcd.usingtlroser'alues.Tlre
best choice then should be thc act'ion
rfith the highest expected uriliq"
tl-re stock ma-rket-iuvestment
example fr-om
As an examplc, Ie I tts reconsiclcr
Chapters5andl2.Yourtillrecalltlratarlinvestorhasfurrdsthathervishestoin-
vest.Helrastl.rreeclroices:ahiglr-riskstock,alow-riskstock,orasavingsaccoullt
rhar rr,ould pa1, $500. If he invisG
in the stocks, he must Pay a $200 brokerage
fee. . r happens to the market' If
n'hat-L^-^.
\\,ith the rrvo srocks his pavoff depends on high-risk-stock and $1200 from
fr"m the
the marker goes .rp, r,.-**iiiJ"rn srzoo the high-
at the same livel' his payoffs for
the lolv-risk stock. If the market sta\s mar-
resPecdvely- Finally' if the stock
and lorv-risk stocks will be $300 and $400' earn $100 frorn
ket goes donn, he rvill tose $g0o
with the iigt -ritt stoc.l.<, but still
that thl market will go uP' s.,y the same' or
the lou.risk stock. Th.';;;;;Uiti,i.,
go dorvn are 0'5, 0'3' a-n-d q'2'.r.esP:cl]tl"'
Figurel3.4shorvshisdecisiontree,includingthebrokeragefeeandthepay-
Note that the values at
nro stocks under different market.o-,,di.io'.u.
offs for the
theendsofthebranchesaretherulpayoff$dlsintoaccountboththebro-
I3.2 gives his utility furrction'
kerage fee and .h. i";:;;;;nt pa1,off.'raute in Chap
values oritre three investments
\Are alread),."r.,rrJrlJ;;;#g.ted
ter 12' TheY are:
EMV(High-Risk Stock) = 580.'
EN{\''(t-$LRisk Stock) = 540
EMV(Savings Account) = 500'
rvouldthoose the high-risk st'ock'
As a result, an expected-r'alue ntaximizer

1 500
High-Risk 1rl0
Stock
(-200) -1 000
(EMV = s8o)
1 000
200
-1 00

500

DeasionTreefm ttw Stock-Madut

Invutot
FIGURE 13.4
370 CHAPTER I3 RISK ATTITUDES

DoUar
Uriliq,
\raluc
l'alue
I 500 1.00
1000
0.86
. 500 0.65
200 0.52
t00 0.46
-100 0.33
-1000 0.00

TABLE t3.2 (ttihtl,

Function
problzm
for tfu Inistment

Figure 13'5 shorvs the investor's

-' decision tree with the utiriq,r.alues
instead
a..ir-i* rree, we calcutate the
ff.1.T[]",::::Hf#* expecied utititl, (EU)

EU(High_Risk Stock)
= 0.63g
' Eu(l.orv_Risk Stock)
= 0.652
EU(Savings Accounr)
= 0.650.
Now the preferred acdon is
to invest in the low-risk stock
highest expected udlity, because it pro*ides the
lngs accounl You can see "r,h;"dl;'d".; ;;;;itd, ,o''.r.n from thai for rhe sar,_
trotithe expected utilities
these invesrmenm in order make it possibre ro rank
"i p..i..1ce;Accolding to the utiriq, funcrion r*e
o,,gr, to n n d &r e h ish-ri, k,,"J'
;:il:::? i| i:,: H::': :f:'.*L:,:t1,, e r e as,;

1.00
High-Risk 0.46
Stock 0.00
(EU =
0.86
Stock 0.52
0.33

0.65

FIGURE l3.S Decision Tieefor Stoc*,-Mat*zt lnvestor

Utihty Valuzs trctea.d oplAn
-
 I

EXPECTED UTILTTY. CERTAINTY EQUIVALENTS,

AAID RJSK PREMIUMS
371
7
+ EXPECTED UTILITY, CERTAINTY
EQUIVALENTS, AND RISK PREMIUMS
Trvo concepts are ctosell'linked to the idea of
expected udliry,. one is t'at of a
certainls- equivabnt, or the amount of money
that is equiralenr in
given siruation that involves uncerrainry. For 'our mind ro a
,;;;^..
lowing gamble: "*".npll,."p;; the for-

Win 52000 with probabitiry 0.50.

I-ose S20 rvirh probabiliry 0.50.
Nor{ imagine that one of 1,our friends is interesred
in aking },our place. ..sure,.
you reply, '['ll sell it to you." After thought and
discussion, ],ou conclude that the
Icast 1,ou rvould sell your position roJis
$300. f;;;, friend cannor pa1, that
*utl' then i'ou r*ould rather keep the gamble. (or course, if .our friend rr.ere
to offer more, you rr,ould take it!)
\bur ccru.intl,equiralenr for the gamble is $300. This is
a sure thing: no risk
is in'olvcd' Frol thrs, (hc meaninglf certainty
eq,ri.aterrt bccomes clear. If
$300 is the least thatyou wourd *:tl for the gambll.
then the gambre must be
equiralent in 1,our mind ro a sure $300.
fr. :,**pl::,
y-9uld
.Il pay thc additional t.^!-.qi1ling of the chapter; Harriman decided thar he
$600,000 simply,to avoid *r. .irti.,ess of the
His thinking at the time was that corn-mitting the situation.
addirional money H.oul6 en-
sure his control of thc Northern Pacific Railioad.
He indicated thar he dici not
\sant to pay morer and so we can think of
$600.,000 as his certainn,equir:alent for
the gamble of purchasing the shares rnore slowry
and risking detection.
lrt us again considcr the stock-market investor. \\'e can make cerrain infer-
ences about his ccrtainty cquiralent for-the
gambles represenred b,, the lors-risk
and high-risk stocks because rr'e have inform-ation
his utilin. function. For
example, his expected utiliq'for the low-risk stock "bort
is 0.65t, .-.hj.; r.l"r, a shade
more than U(5500) = 0.650. Thus' his certainry equir:alent
musl be onll'a little more than 5500. Likervise. his
for the lox.risk stock
expectecl utilin.for the high-
risk stock is 0.638, rvt'rich is somervhat ress than
0.650. il;.;;;.. h"is ce.tainn,
equiralent for the liigh-risk stock musl be tess that
$500 btrt not as litrle .;;;,
rtliich has a utiliq,of 0.520.
\bu can see also [ha[ rte can ratrk the investmenL< bv their
Ie.... The lrigh-risk stock, ha'ing the rorvesr ."r,ri.r* certainn.equi'a-
fcrred' The lorr'risk stock, on,li. other hand, l',as .q;,..,;".1;;;; ,.r., pr"-
ihe tign.., certainn equir.a-
le.t, and so is the most preferred. Rankirrg alter.,r,ii=.
equirale,ts is the same as ranking them by theii ;r. ,n;;; certaing,
.*p..,J
ti*es ha*e the same "u,tI;r. if'.,r o'"',..nr-
certainn.equirarent, tir"n they m.r.t har.e the same
expected
utilit\" and the decision maker rvould be indiffer.n,
,o a choice ben*een [he rrr.o.
Closell'related to the idea of a certaing,equivalent
is the nodon of risk pre-
rniurn' The risk premium is dehned as
ttre diff.r.n.. benteen the Elr{\- and rhe
certain q' equ ir.alen t:

Risk Premium = EMV _ Certainty Equivatent.

"., CHAPTER I3 RISK ATTITUDES
- \

consider the gambre berween rvinning

$2000 and rosing $20, each nith proba_
bility 0.50. The EMV of rhis gamble is
$ggO. On reflection, vou assessed your
tainty equivalent to be $300land so your cer_
risk premium is
Risk, premium = $990
- $g00
= $690.
Because'you tvere rvilling to trade
the gamble for $300, yo.u \l.ere rvilling
up" $690 in expected value in order to ro ..giye
avoid the risk inherent in the'gamble.
You can think of the risk premium
as the premium you pay (in the
opporruniry) to avoid the risk. sense of a lost
Figure l3'6 graphically ties together utiliry
functions, certainry equirralents,
and risk premiums' Notice that thJ certainv
equirralent.and the expected utiricy
of a gamble are points that are "matched
,p" uy ttre utirity function. That is,
EU (Camble) = 1116.rtainty Equivalent).
In words' the utility of the certainty e.quiralent
is equar to the expected utilicy of
the gamble. Because these nno qr"r,,i,i.,
are equal, the decision rnaker must be
indifferent to the choice benpeen them. Afterail,
tainry equivalenu
--- ---' tr,"t
E' is the meaning of cer-

Now we * p",_1tof the pieces.tog:g..

in Figure 13.6. Imagine a gambre
has expected utility I'. The rralue I/is
in utility units, and so we must first locate y
on the vertic'l axis. Trace a horizontal line
'the line intersects from the expected utiliw point until
ttre utility curve. Now drop down to the horizontal
the certainty equivalent. The difference axis to find
between the expected ralue and the cer-
tainty equivalent is the risk premium.

tltility 1y1

Expecled
Utility

Certainty
Equivalent
(cE)
Expecled
Value
(El"M f
FIGURE t3.6 Gaphicat Representation of Risk kemium
 EXPECTED IJTILITY. CERTAINTY EQUIVALENTs, AND
RISK PREMIUMs 373

I'-or a risk-avcrse irtdividtral, the irorizonul EU line reaches

the conca'e udl-
itY cttrvc l>eforc it rcachcs lhe rcrtical Iinc that corresponds to
tl.re expectecl
r':llttc. Tlttrs, lor a risk-avcrse indiridtral the risk premium must be
positiye. If the
trtilit)' [unction werc convex, t-lle horizontal EU line would reach the expecteci
valuc l;cforc the utilitl' curvc. The certainty equivalent would be greater
than
tltc cxpccted valuc, and so ihe risk premium rvoutd be negative. Th]s would im-
1>lv tlrat tlrc dccision nrakcr rvoulcl have to l>e paid to give up an opportuniry to
gamble.
In anl'givett situati<-xt, the certaintl'equivalent, expected rralue, and risk
pre-
ttritttn all depend on n\'o factors: the decisio,r makerls utility function
and t5e
probabilin' distribution for the pavoffs. The probability distritution for
rhe par-
offs determines the expected value. The valuls that the payoffcan
12ke combine
rvith the probabilities to also determine the EMV. fne utiiity funcrion,
couple d
rr'ith the probabiliq'distribution, determines rhe expected utility and
hence rhe
certainty equivalent. The degree to rvhich the utility curve is nonlinear
deter-
nrines the distance beBseen the certainw equiralent and the expected
pa'off.
If t-he certainty equiralent for a gamble is assessed directly, then nnaing ttre
risk premium is straightfonvard the EMV of *,. gamble and
subtract the assessed certainn' equiralent.- simply calculate
In other cases, the decision maker
may have assessed a utiliq'function and norv faces a particular gamble
rhat he
or she rt'ishes to analyze. If so. there are four steps in finding th"e gamble's risk
premium:
l. Find the EU for the gamble.
2. Find the certaintl' equiralent, or the sure amount that has the utilin. value
equal to the EU that rr-as found in Step l.
J. Calculate tlie EMV for rhe ganrble.
4. Subtract tlie certainn' equiralent from the expected pal,off
to find the risk
premium. This is the difference behveen the expected Value of the riskr.situa-
tion and rhe sure amounr for rr'lrich the risky situation would be traded.
Here is a sirnple example. Using the hypothetical utilin'function gir.en in
Figtrrc 13.7. rvc rvill find the risk prernitrm forl the following gamble: u
\\'in 54000 rr'ith probabiliq, 0.40.
,, \{'in 52000 rr.ith probabilin, 0.20.
\{'in S0 rr'ith probabilitr. 0.15.
Lose 52000 rr'ith probabiliq, 0.25.
The 6rst step is to find the expected utilirr.:
EU = 0.40 u(g4000) + 0.20 u(s2000) + 0.rb u(g0) + 0.25 u(-$2000)
= 0.40 (0.90) + 0.20 (0.82) + O.rS (0.62) + 0.25 (0.38)
= 0.72.
The second line is simptv a matter of estimatirig the utiliries from Figure 13.7
and substituting them into the equarion.
::7
4 \
CHAPTER I3
RISKATTITUDES

1.00

o.B0

0.60

0.40

0.20

-3000 i

4CO0

FIGURE I3.7 {Jtility Funaionfor

a Risk_Auase Decision
^r*
equirarent i1 the
::d":T! l$:.::"'i:.v
n"aii,f,r,l-..'#-ttttd utility
sure amount that
of the gambte. rigr..'is.S_shows srves rhe same
;h.-;;..ss or

[i{iH1ffi?{t;#j[*rl[,ff .'.'t':]II.Tr"'dti;n::
t"it'ty.q"i*r.",i, ts.s, *..-;r,:;'Lr1in.
*pp.o*imatery .".-
Figure
*rjbl'"-

FIGURE I3.8 Finding a C.atainty

tqu;oat"rt
 UTI LITY FUNCTION ASSESSMENT
375

Step 3 calculares the expected payoff or EN4V:

EN[v = 0.40 ($4000) + 0.20 ($2000) + 0.r5 ($0)

+ 0.25 (_g2000)
= $1500.

step 4, tve calculate the risk premium by subtracting

.Finally,-in
equivalent from the expected payoff:
the certainry
*
Risk Premium = g1500
- $+OO = $l100.
i KEEPING TERMS STRAIGHT
- one problem that students
often have is that of confusion about the terms
we use in utility theory. The basic idea, remember, that
is to use a utility function to
translate dollars into utility units. Ifwe compare hvo
risky projec6; ,rr.i*i. or
expected utility (EU), we are rsorking in utitity units.
when we calculare cer-
tainty equirralents or risk premiums, howeveq we are working
' in dollars. Thus, a
certainty equiralent is not the same e.
t expected utiliri.of a gamble. The t*,o
measurements provide equiralent informadon,
but only in th; sense :hat the
certainry equivalent for a gamble is the sure arnount
that gives the same utiliq, as
the expected utility of the gamble. The translation
from certainty equi,alent to
expected utilicy and back again is through the utility
funcrion, as depicted in Fig-
ures 13'6 and 13.8. Again, a certainty equivalent is a
dollar amount, whereas ex-
pected utility* is in utility units. Be careful to use these
terms consistenrly.

$ UTILIW FUNCTION ASSESSMENT

Different people have different risk attitudes and thus
are willing to accepr
different levels of risk- some are more prone to taking
risks, while others are
more conservative and avoid risL Thus, assessing a utili[
function is a matter of
1.b..lgcti.r'ejudgment' just like assessing subjective"probauitities. In this section we
rvill look at Nvo utiliq'2s5.ssment .pf-".n.s thai are
based on the idea of cer-
tainry equiralents. The follorving r..io, introduces
* .r,...,.tr. .-ppr}.n
.
It is rvorth repeating at thii point our credo about
modeling and decision
making' Remembel that the objective of the decision-analysis exe?cis.
is to help
)'ou make a better decision- To do this, we construct a moiel, or representation,
of the decision. when tve assess a utility function, we are
constructing a mathe-
matical model or re.Presentation of preferences. This
representation then is in-
cluded in the overatl model of the decision problem
and is used to analyze the
sttuat'ion at hand. The objecti*e is to find a way
to represenr p..f"r..r... ltrr, i.,-
corporates risk atdtudes. A perfect representation is
,ro, .r...rsary. All that is re-
quired is a model that .eprir.nt, feelings about risk well
enough ro understand
and analyze the current decision.

Assessment Using Certainty Equivatents

The first assessment method requires the decision
certainty
maker to assess several
equivalents. Suppose 1ou face an uncertain situation
in which you may
376 CHAPTER t3 RtsK ATTtTuorc

\vorsr case' gr00 in the best casc, or possibrl,somerhing

l#:Jl9J"r:1" in
;:i# jri:xlm::i
be-

il';::T::ilri[rr:ifj;ir*;:ll:ffi
H/c can
. gcr trrc first h1,o points of
i,orrr uririry functjon by arbirariry, ser_
ilL.,J', $?"' lol"l F,H"t i,ll,,;''- :: :'-T I'#', stranse''b;; ;;''*i e x-
L o,,, w" .*
r
1',

and muldply by"iJ;

;;.t ;",1,i I il il, lJ; ;:;. ffi "01' y
?J:.::.: : :r.T *,"..,,,,T;
a positi'e constant so rha[
a.d rhe u'orsr ,1T the best ourcome has a utirity
- ,"ra;;j;nrs
utiriry of 0. The of
"rvill be ;;' "-.., risky situations in rermsI
ror both theooriginar and ..*J.a
. []::'i'flrlj:"o
udriry
we. are besin"'#';:'":r'J:i5:i: *oing adrantage-"r il
mai ng .i.*
rescare.ti: "uitq,
ni
(\{e courd j'st ",,
ts
en rvi r r be
ch :#[::"tJ;:;,
ift^H,: tl,r?T: ]ffi
as we, set the endpoints
are using I and 0 because at roo r.i-0, or r00 and _50, say. \\/e
.

this chlice or..raioin,J,rrn

we rt'ill have to be careful .,o, our ro be particurarrl,
;Hilffi:.,]" ,o confuse these utrities r*irh
imagine that you have thIe
, . Io,u
-which opPortunin' t, play the follorving lottery,,
w. wirr?"iJa refermce lnttery:
\4rin gl00 with probabiliq,0.5.
Win gt0 with probabitin.0.5.

u'i,,ing ,o
se,, vour oppor-
iffi,i"t"T';l,TJ*:l#j;:;Il:'LlH
(CE) for this reference
gamble' A ;^',1:"
x11i3;
rs to nnd yoLrr ceraincy
equivalent
decision tree for your choice
Figure I3.g. is shorrn in
. Finding your certainq,equirarent is r*here'our subjecd'e judgmenI
rnto play. The cE undoubieary
this reference gambr.
*iii*r.1-from p.rro' io p.r*.,. Suppose comes
yor. ..ioirf .quirarent is S30. that for
That is, for $3r you rvourd

FIGURE 13.9 A "fufaence

Gambb,for,Assessing
a Utitity Function
Yourjob is to find the cerainry
(CE) so thar you ar:e indifferent equivalent
to options
A and B.
 7
UTII-II-I ;-', ]i,].i ASSESSMENT 377

F
t:..:c tire rnone)', but for $29 you would rather play the lortery; $30 must be your
u ue indifference point.
The key to tlte rest of thc analysis is this: Because you are ind.ir(fcrcnr berween $30
nnd llu nslq gantbb, tfu utility oI $30 must equal tltz expecicd utiLity of tlrc gambb. \\te
knorv the utilities of $10 and $100, so we can figure our rhe expected utitiry of
thc garnblc:
U(30) = 0.5 U(100) + 0.5 U(10)
= 0.5 (t) + 0.5 (0)
= 0.5.

We have found a chird point on your utility curve. To 6nd anorher, take a differ-
. ent reference lottery:

Win $100 with probabiliry 0.5.

Win $30 with probabiliry 0.5.
Norv frnd your certainty equivalent for this new garnble. Again, the certainry
equivalent will vary from person to person, but suppose that you settle on $50.
We can do exaccly what we did before, but with the nerv gamble. In this case, \\/e
can find the utility of $SO because we know U(100) and U(30) from the previous
assessment.

U(50) = 0.5 U(100) + 0.5 U(30)

= 0.5 (i) + 0.5 (0.5)
= 0.75.

This is the fourrh point on your utility curve.

Now consider the reference l.'ottery:

Win $30 with probability 0.5.

Win $10 with probability 0.5:
Again you must assess your CE for this gamble. Suppose it turns our ro be $18.
Now we can do the familiar calculations:

U(18) = 0.5 U(30) + 0.5 U(I0)

= 0.5 (0.5) + 0.5 (0)
= 0.25.

We now have five points on your utility curve, and we can graph and draw a
curve through them. The graph is shown in Figure 13.10. A smooth curve drawn
through the assessed poins should be an adequate representation of your utiliry
function for use in solving your decision problem.

Assessment Using Probabilities

The cE approach requires that you frnd a dollar amount that makes you
indifferent benveen the gambte and the sure thing in Figure 13.9. Another ap
l-
3TB CHAPTSP ATTITUDES

Utility

1 .00

0.7 5

i
0.50

0.25

20 40 60 80 100 Weatth

FtcURE t3.t0 Apfh of tlu Utili$ Funaion

Assessed,
Using the ktaintyfiquiaalent A p pro a ctt

proach invoives setting the sure amount in Alternacive

abiliq'in the reference gamble to achieve indifference. and adjusting the prob-
B
\,tre will iall thfs the pro&
a bili ty < q uiu alent ( pE
) assessm e n r te c h n iq u e.
example, suppose you \{ant to knoir.r.our utility
for $65. This is nor one
of the certainty equivalents that you asses.sed,
,rr"r u(6s) is unknown. you
could rnake an educated gu.tt- Based on rhe ^"aprerious
assessments and the
graph in Figure 13.10, urosl musr be benreen'0.75
and 1.00; it probably is
around 0'85' But rather than guess, you can assess
the value directly. consider
the reference lottery:

Win gl00 rvith probability p.

Win gtO with probabiliry (I _p).
This gamble is shonn in Figure 13.l l.
. To find your utility value for $65, adjust p until you are indifferenr benveen
the sure $65 and the refe^rence gamble.
ihr,ir, think about rrarious probabilities
that make the chance^of winniig
$100 grearer or less until you are indifferenr
behveen Alrernative:.c ._"d D in"Fitur.
you know that U(100) = I and U(10"; g;
ir.t i. N.*1., can find u(6s) because
=
U(65) =p U(100) + (l -- p) U(r0)
=pe)+(l_p)(0)
=p.
The probability that makes- indifferen,^jT, happens to be your utility
value for $6S. For example, ifIou
you chose p = O]S? ,o
u(65) = 0.87. indifference, then
"lni.u.
S.]SK TOLERANCE AND THE EXPONENTIAL UTILITY FUNCTION
379

$100

$10

FIGURE 13.l I A fufnznct Cambb

for Assessing tlu Utilitt of $G5 Using the probabitity_
Equivabnt lttethod
 )

l;
fusk aversion and insurance

THE DEI{A}.D FoR NS,RANCE

Risk aversion provides a read.y.explana_
tion concerning the dentand for
insurance. Insura
[ *" :: r."
n s ate rh e u p o ticyho tders
#.. ."#: J,::fi ;: :H j
in th e
,rre cus,o m., .:fi:fflii
H5Gff f## *: ffi,H: Ef,:
risks' In effecs this is wh"r th.y do-whJn "*
f;[ff,I[[.:o 'uoid they
To make the argument concrete, consider
a coupre $,ho is about to
purchase fire insurance to protect
theirhome (wr,icr, isrrrrued at$150,000).
The risk of a fire destroying their horrse
is very small_about I in 300
any gi'en year. Neve.ct,eiei the in
ross of their house wourd mean
ruin. Thus, ft" .^"yl]e finds ir prudent financia-l
to purchase insurance. In recurn
for payrnenr oF a $soo annuai p.emium,
ro pay r*rlate'er amount is neiessary
, 1oo p.r.".r, fire policy promises
to rebu,d and reprace the house
the evenr of fire-. in purety financiar iri
,"Trrl *,. .orrpt. t.., tr.," rorror"irrg
options. If tirey buy rhe poricy, their weaith'at the.end.of
r*ili be $ i50,000 9^o."o,
if there is no firi o. $o if a fue o..r", (a 1-in-300 the year
Tireir expected r'earrh is g149,500 chance).
rr-.:I gi, r gy;*.hasing the poticy,
is $I50,000 - $500 =
-U]"':,":Xait'
*rcalth is ciitzin. Regzrdless of $i49,500 tnJena of rhe year. Their
"t
whether a fire,occurs, they rvirl have their
house (or tile money ro rebuitd
it). Norice that whether or not they
chase insurance,,*re coupre's pur_
expected wearth is the same,
cause rhel'are risk a'erse, the $14g,500. Be_
coupre prefers *,...raio
$I4g,500 provided
:il#ffii;::L*"":r,ernarive oi u.*i,,g the risk of sre. Thus, ;_,.y;r._
In this exampre, the company has offered
the coupre *actuaria[y fair,
insurance; rhat ii, rhe coupre ,
expected payour oill:l !$590) 3*t.ou"., the company,s
i"g:l
their iarge size and
rhe potiqn f rZsodifsrsd,o-ool : $500. Because of
ab,icy to poor'diffe..",'irr.r, ir..rorrce
erally behave * companies gen_
o,r.y are riJk neutrar. To iriusrrate,
company insures t:rsh
300,000 homes in a state against fire.
suppose the
possible to predict which houses Although it is im_
wil^tte-stru.fuln.", ar,e raw of large num_
bers indicaces rhac very close
a i,ooo homes i" aor wir.r have fire losses.
Thu;, rhe toul premiums ($I50 millio.n)
actual payouL Because of ad.ministrative
*iff .L"Jy _"Lfr;;;;;rrr,,
cosrs in *a,i.,g the. policies,
sur.ance cor*pa,ies typical.ll in_
. chaqge premiurns that exceed their expected
tosses' (of course, competition-a-riong
insurance companies rimits the pre.
an)' one .o*p..,y cah chargei r",
I11*:
rnare (although they may reduce) r.rg;I"rnir*, do nor elim_
the.deman? roJirrru.ance. Even
i€ the
insu3nce prcmium were
[1e
reap ar rhc r:rrance $1,000 per yeaq t]re risk
to buv."";;;. rather than go might
",,i::[l;ra:fre