FINANCIAL ECONOMICS

Lecturer： Quyen Do Nguyen, PhD

Corporate Finance Department
Faculty of Banking and Finance
Foreign Trade University
Email： quyendn@ftu.edu.vn

Course Materials: https://www.dropbox.com/sh/bhbsaz4t8ehyk50/AADaldsAfMk

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CHAPTER 3: INVESTMENTS UNDER

UNCERTAINTY
 Main content
3

 Investment decision when risks are involved

 Optimal investment under uncertainty

 Five axioms of choice

 How the investors rank investments opportunities
 Theory: Mean-variance theory of choice.
 Usingmean and variance to rank
 The mean – variance indifference curve

The indifference curves

4

Three types of indifference curves

 Commodity indifference
curve
 Consumption trade – off
indifference curve
 Risk – Return indifference
curve
 All types difference curve
derives from UTILITY THEORY
 5 axioms of investor choice
5

 On what instincts do the investors make the investment decision?

 Axioms: Conditions/ Principles to consistently rank the opportunities
 Axiom I: Comparibility or Completeness
 For the entire set of uncertain alternatives, an individual can say either the
that either the outcome 𝑥 > 𝑦 𝑜𝑟 𝑦 > 𝑥 𝑜𝑟 𝑥~𝑦
 Axiom 𝐼𝐼: Transitivity
 If an individual prefers 𝑥 to 𝑦 and 𝑦 to 𝑧 then 𝑥 is preferred to 𝑧
 If 𝑥 > 𝑦 𝑎𝑛𝑑 𝑦 > 𝑧, 𝑡ℎ𝑒𝑛 𝑥 > 𝑧
 Same with the indifference case
 If 𝑥 ~ 𝑦 𝑎𝑛𝑑 𝑦 ~ 𝑧 𝑡ℎ𝑒𝑛 𝑥 ~ 𝑧

5 axioms of investor choice

6

 Axiom 𝐼𝐼𝐼: Strong independence

 Define a gamble 𝐺 𝑥, 𝑧: 𝛼
 Win gets 𝑥, Lose gets 𝑧, Probability of winning is 𝛼
 𝑧 𝑎𝑛𝑑 𝑥 are mutually exclusive

 Soif 𝑥 ~ 𝑦 then 𝐺 𝑥, 𝑧: 𝛼 ~ 𝐺 𝑦, 𝑧: 𝛼
 Axiom IV: Measurability
 If𝑥 > 𝑦 ≥ 𝑧 𝑜𝑟 𝑥 ≥ 𝑦 > 𝑧 then there will be a probability
(chance) 𝛼 that makes 𝑦 ~ 𝐺 𝑥, 𝑧: 𝛼
 Meaning: Every continuous point ∈ [𝑥, 𝑧] can be measured.
 5 axioms of investor choice
7

 Axiom 𝑉: Ranking
 Consider 𝑥 ≥ 𝑦 ≥ 𝑧 𝑎𝑛𝑑 𝑥 ≥ 𝑢 ≥ 𝑧 and
𝑦 ~ 𝐺 𝑥, 𝑧: 𝛼 , 𝑢 ~𝐺 𝑥, 𝑧: 𝛼
 If 𝛼 > 𝛼 then 𝑦 > 𝑢
 If 𝛼 = 𝛼 then 𝑦 = 𝑢
 Meaning: The gamble outcome is a Monotonic function of the
probability.

Utility Function
8

 Building the Utility Functions on the basis of 5 axioms.

 Why building Utility functions?
 To compare and Rank investment opportunities
 Utility functions properties
 Order preserving (Monotonic function)
 Can be used to rank the opportunities.
 Representing the outcome of the investment opportunity.

 The model

 Does this function satisfy the above properties?

 Utility Function
9

 𝑈=𝑓 𝛼

 Order preserving: If 𝛼 > 𝛼 then 𝑈 > 𝑈

𝑈 = 𝛼 𝑈 𝑥 + 1 − 𝛼 𝑈(𝑦)
 𝑈 = 𝛼 𝑈 𝑥 + 1 − 𝛼 𝑈(𝑦)

 If𝛼 >𝛼 →𝑈 −𝑈 = 𝛼 −𝛼 𝑈 𝑥 −𝑈 𝑦 > 0 → Order

preserving
 𝑈 can be used to rank risky alternatives
 Using 4th and 5th Axiom

Expected Utility of a gamble

10

 The expected Utility is the linear

combination of all Utilities of outcomes (2).

𝑧 ∈ 𝑥, 𝑦
 If the Gamble entails multiple risky
alternatives
 Investment decision procedures
11

 Step I: Calculate the expected Utilities of all investment

alternatives.
 Need to estimate the alternative outcomes and the
respective probabilities
 Step II : Rank the Expected Utilities

 Step III: Choose the project with maximum Expected Utilities

Constructing the investor’s utility function

12

 Assign a loss of $1000 cause a loss of 10 utiles (Utility unit)

 An investor plays a gamble: G($1000, -$1000: 𝛼) What would make him/her
indifferent between the gamble and $0 with certainty?
 Mathematically,

 Assume 𝛼 = 0.6 makes the investors indifference 

(u)
 Investor’s utility function
13

 Repeating this process while changing the probability 𝛼

$ Loss
$ Loss $ Winning
$ Winning Winning
Winning
Probability
ProbabilityWinning
Winning
Utile
Utile Losing
Losing
Utile
Utile

Investor’s Utility Function

14

 Is this investor risk

neutral, risk adverse
or risk lover?
 Risk aversion measure
15

 Traditional view: 3 Types of investors: Averse, Neutral, Lover.

 Assumption: All types prefer more to less

Risk aversion measure

16

 Measuring risk aversion with a trial

 Consider a gamble G(𝑎, 𝑏: α)
 Should the investor choose the expected return of the gamble
with certainty or to play the game?
 Risk aversion measure (contd.)
17

 A game: 𝑎 = $30, 𝑏 = $5, 𝛼 = 20%, U = ln(W)

2 scenarios of the game
 Based on the actuarial value of the game: 30 .2 + 5 .8 = $10
 If the investors receive the actuarial value of $10 with the probability of 100%, their
utility will be:
𝑈 𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑊 = ln 10 = 2.3
 Based on the average utility of all outcomes
 If the investors get involved in the game
𝐸𝑥𝑝𝑒𝑐𝑡𝑒𝑑 𝑈(𝑊) = .2 ln 30 + .8 ln 5 = 1.97
 Which scenario of the game is more preferred? Why?

Risk aversion measure

18

 In general
 If 𝑈 𝐸 𝑊 > 𝐸 𝑈 𝑊 → Risk-adverse investor
 The investor perceives the Utility of the gamble 𝐸 𝑈 𝑊
 If 𝑈 𝐸 𝑊 = 𝐸 𝑈 𝑊 → Risk neutral investor
 The investor is indifferent between two methods
 If 𝑈 𝐸 𝑊 < 𝐸 𝑈 𝑊 → Risk-loving investor
 Prefer to play the gamble more than receiving the certainty equivalent
outcome.
 Risk premium
19

 How much will the investors be willing to pay to avoid the risk of
the game?
 An investor A, currently has $10. A is offered a game with a chance of
winning $30 (20% chance) and losing $5 (80% chance). After taking
part in the game, A either has 40 or 5. How much will A be willing to
pay to receive $10 for certain in the game? Taking part in the game is
compulsory and there is no fee needed.

Risk premium
20

 Risk-averse investors consider the result of the game as 𝐸 𝑈 𝑊

𝐸 𝑈 𝑊 = 1.97 → 𝑊 = $7.17
 7.17 is certainty equivalent

 As for risk-averse investors, this certainty equivalent of the game is

smaller than its expected value ($10).
 Therefore, the investors are willing to pay the risk premium: 10-
7.17=2.83 to receive $10 for certain.
 If the insurance company sell the insurance package to ensure that the
investors will receive $10 for certain when taking part in the game with the
premium <=2.83, the investors will surely buy the package.
 Risk premium
21

Risk aversion measure: The alternative method

22

 Pratt(1964) and Arrow(1971) method

 Assuming B initially endowed W, facing an actuarially neutral gamble 𝑍, 𝐸 𝑍 = 0.
How much should B pay for the insurance firm (risk premium) to be indifferent between
receiving the expected outcome with certainty and playing the game?
 Risk premium is a function of W 𝑍 Premium = 𝜋 𝑊, 𝑍
 B is indifferent between the two alternatives:

 𝐸[𝑈 𝑊 + 𝑍 ]: Expected Utility of the game

 𝜋 𝑊, 𝑍 : Risk premium
 𝐸 𝑍 = 0:
 Taylor series
23

A Taylor series is a series expansion of a function around a point. A one-dimensional Taylor

series is an expansion of a real function f(x) about a point x=a is given by
Condition: 𝑓 𝑥 has nth order derivative.

Set ℎ = 𝑋 − 𝑎

Taylor series
24

 Taylor series expansion

Terms of second order onward

Terms of third order onward

Terms of third order onward

since
 Risk premium: Pratt-Arrow
25

 Risk premium

Pratt Arrow Risk Premium

Absolute risk aversion

ARA and RRA are used to assess the

Relative risk aversion
Utility function.

Exercises
26

 Calculate ARA and RRA for the following functions:

 Exercises (contd.)
27

 Second-order function

2𝑏
𝐴𝑅𝐴 =
𝑎 − 2𝑏𝑊

Exercises (contd.)
28


 Risk premium: Measure of risk aversion
29

 Pratt-Arrow method
 Risk premium = ARA or RRA
 Condition: Low-risk, actuarially neutral game (expected result=0)
 Markowitz method
 Risk premium = 𝐸 𝑊 − 𝑊
 Pratt-Arrow conditions are not applied
 Markowitz vs. Pratt-Arrow
 Consider an individual with utility function U= ln(𝑊) the initial endowment
𝑊 = $20,000. He/she is facing two gambles:
 Gamble 1: win $10 and lose $10 with 50/50 chance.
 Gamble 2: lose $10,000 (probability 20%) or lose $1000 (probability 80%)
Calculate the risk premium using both methods for both gambles.

Risk premium: Measure of risk aversion

30

 Pratt-Arrow

 Gamble 1’s risk:

𝜎 = (20,010 − 20,000) + (19,990 − 20,000) = 100
 Risk premium: Measure of risk aversion
31

 Markowitz

𝜋 = 20,000 − 19,999.9974998 = 0.0025002

Risk premium: Measure of risk aversion

32

 Gamble 2
 Markowitz risk premium: $489
 Pratt-Arrow risk premium: $324

 With low risk, 2 methods produce the same results.

 When Markowitz method produces different results compared with
Pratt-Arrow method
 When risk is high, prefer Markowitz method.
 Pratt-Arrow is meaningful in identifying an appropriate utility function
 Ranking assets
33

 1st order stochastic dominance:

 Asset A is preferred to Asset B if A yields
higher Utility than B in all economic scenarios.
 𝑥 is preferred to 𝑦 if 𝐹 𝑊 ≤ 𝐺 𝑊 for all
𝑊
𝐹 𝑊 , 𝐺 𝑊 are Cumulative Distribution
Functions of 𝑊
 The utility function is, presumably, order preserving
 𝑥, 𝑦 follows normal distribution with the distribution
function

Ranking assets
34

 Risk adverse, neutral and lover prefer

𝑥 to 𝑦 because 𝐸 𝑈 𝑊 𝑥 >
𝐸[𝑈 𝑊(𝑦) ] for all order preserving
utility function

𝑓(𝑊) is the probability of the state

 The reverse result for non-increasing
utility function
 Ranking assets
35

 Ranking order 2
 Assuming concave utility function
 Order preserving
 Concave

𝑥 is ranked higher than 𝑦 for all 𝑊 if:

Ranking assets
36

 2nd order stochastic dominance:

 Concave utility function ∆𝑈 > ∆𝑈
 For Linear Utility function ∆𝑈 = ∆𝑈 , Risk
neutral investor 𝑥 = 𝑦
 𝐶𝐷𝐹(𝑓 𝐺 𝑊 − 𝐺 (𝑊) ) > 0
 Thus, 𝑥 is preferred to 𝑦
 Mean – Variance ranking method
37

 Ranking assets on the basis of 𝜇, 𝜎

 𝑋~𝑁 𝜇 , 𝜎 , 𝑌~𝑁 𝜇 , 𝜎 → 𝑍 = 𝛼𝑋 + 𝛽𝑌 ~𝑁 𝜇 , 𝜎
 If X and Y are both normally distributed, the linear combination
of X and Y also follow normal distribution.
 𝜇, 𝜎 are the first and second moment of the series, respectively
 3rd and 4th moment are skewness and kurtosis
 𝜇 is the expected return, 𝜎 the standard deviation of asset
return

Mean – Variance ranking method

38

 Assuming one – period context:

 If 𝑊~𝑁(𝑊 , 𝜎 ) then 𝑅 𝑖𝑠 𝑛𝑜𝑟𝑚𝑎𝑙𝑙𝑦 𝑑𝑖𝑠𝑡𝑟𝑖𝑏𝑢𝑡𝑒𝑑

 Expected return: 𝐸 𝑅 = −1
 Variance: 𝜎 =

Because : 𝜎 = 𝐸[𝑅 − 𝐸 𝑅 ]

𝑊 𝐸 𝑊
= 𝐸[ −1− + 1]
𝑊 𝑊

1 𝜎
= 𝐸[𝑊 − 𝐸 𝑊 ] =
𝑊 𝑊
 Mean – Variance ranking method
39

 If asset return follows normal distribution with mean 𝐸 and standard

deviation 𝜎, the Utility function of this asset according to Tobin (1958)
is:
𝑈 = 𝑈 𝑅 , 𝐸, 𝜎
 Expected Utility

 Where: 𝑓(𝑅; E; 𝜎) is the probability distribution of asset return 𝑅

Mean – Variance ranking method

40

 Risk averter indifference curve

 The indifference curve comprises
all investment opportunities having
the same expected Utility 𝑬(𝑼)

 Indifference curve is convex

 For risk averter only
 Mean-variance method
41

States of the economy

Very bad Bad Average Good Very good
Operating profit
42
Probability

FIRM A

Interest

Income before tax

Tax 50%

Net income

EPS (200 shares)

FIRM B

Interest

Income before tax

Tax 50%

Net income
43
($2.82, $7)

($1.41, $5)

Risk aversion 𝑰𝑰𝑰 > 𝑰 > 𝑰𝑰

44
45

46
 Drawback of mean-variance
47

 Mean-variance  A > B

 Second-order statistical dominance  A < B

 Mean-Variance assumes that asset return is normally distributed while
EPS is NOT normally distributed in the example.

To conclude…
48

 5 axioms of investor choice

 Constructing utility function on the basis of 5 axioms
 The investment decision is made through maximization of
Expected Utility
 Measuring risk aversion (risk premium)
 Markowitz
 Pratt-Arrow
 Assets ranking
 Stochastic dominance order 1
 Stochastic dominance order 2
 The indifference curve in the mean-variance space.
 Practice exercises
49

Exercise 1: Suppose you have a logarithmic utility function

U(W)=ln(W) and are exposed to the probability 30/70 of wining
$10,000 or losing $2,000.
(a) How much are you willing to pay for the insurance fee if your
current wealth level is 10,000$?
(b) How much are you willing to pay for the insurance fee if your
current wealth level is 1,000,000$?

Practice exercises
50

Exercise 2: You have estimated the following probabilities for EPS of companies A and B:

Probability Company A Company B

0.1 0 -0.5
0.2 0.5 -0.25
0.4 1 1.5
0.2 2 3
0.1 3 4
(a) Calculate the mean and variance of EPS for each company.
(b) Explain how some investors might choose A and others might choose B if preferences are based on
mean and variance?
(c) Compare A and B, using the second-order stochastic dominance criterion.