Utility function

𝑥 ≽ 𝑦 ⟺ 𝔼[𝑈(𝑥)] ≥ 𝔼[𝑈(𝑦)]
Any affine increasing transformation can be applied to the utility function, such as
𝔼[𝑎 + 𝑏𝑈(𝑥)] ≥ 𝔼[𝑎 + 𝑏𝑈(𝑦)] → 𝑎 + 𝑏𝔼[𝑈(𝑥)] ≥ 𝑎 + 𝑏𝔼[𝑈(𝑦)] → 𝔼[𝑈(𝑥)] ≥ 𝔼[𝑈(𝑦)].
If an agent is risk averse, its utility function must increase:
𝑈(𝔼[𝑊 ]) > 𝔼[𝑈(𝑊)] → 𝑈(𝔼[𝑊 ] − 𝜒) = 𝔼[𝑈(𝑊)]
𝜒 is a risk premium. If we expand the right-hand side with Taylor series up to the second
order around 𝑊 = 𝔼[𝑊 ], we get:
1
𝑈(𝑊) ≈ 𝑈(𝔼[𝑊 ]) + 𝑈 ! (𝔼[𝑊])(𝑊 − 𝔼[𝑊 ]) + 𝑈 !! (𝔼[𝑊])(𝑊 − 𝔼[𝑊 ])"
2
Whose expected value is
1
𝔼[𝑈(𝑊)] ≈ 𝑈(𝔼[𝑊 ]) + 𝑈 !! (𝔼[𝑊])𝕍[𝑊]
2
If we expand the left-hand side with Taylor series up to the first order around 𝜒 = 0, we get:
1
𝑈(𝔼[𝑊 ] − 𝜒) ≈ 𝑈(𝔼[𝑊 ]) + 𝑈 ! (𝔼[𝑊])(𝑊 − 𝔼[𝑊 ]) + 𝑈 !! (𝔼[𝑊])(𝑊 − 𝔼[𝑊 ])"
2
Whose expected value is
𝔼[𝑈(𝑊)] ≈ 𝑈(𝔼[𝑊 ]) − 𝑈 ! (𝔼[𝑊])𝜒
So:
1
𝑈(𝔼[𝑊 ]) + 𝑈 !! (𝔼[𝑊])𝕍[𝑊] = 𝑈(𝔼[𝑊 ]) − 𝑈 ! (𝔼[𝑊])𝜒
2
And
#$#
1 ;<
𝑈 !!<=< <>
(𝔼[𝑊])
𝜒=− 𝕍[𝑊 ]
2 𝑈 ! (𝔼[𝑊])
A “good” utility function is increasing and concave.
1. Compute the domain of the function
2. Check the behavior of this utility in the boundaries of the domain by computing
lim 𝑈(𝑊)
%→'()*+
3. If it is necessary to discuss a parameter 𝑘, compute lim 𝑈(𝑊)
,→-./0/-12
34(%)
4. Compute 𝑈 ! (𝑊) = 3%
> 0 (Gossen’s first law, marginal utility positive)
3 ! 4(%)
5. Compute 𝑈 !! (𝑊) = 3% !
<0
4 "" (%)
6. Compute 𝐴𝑅𝐴 = − 4 "(%)
4 "" (%)
7. Compute 𝑅𝑅𝐴 = − 4 "(%) ∗ 𝑊
8. If there are two different utility functions, compare the 𝐴𝑅𝐴 and the 𝑅𝑅𝐴 indices
9. Chose the Utility function family

9
78
(𝛼 + 𝛾𝑊) : − 1
𝑈(𝑊) =
𝛾−𝛽
;
𝑊 ∈ K− : , +∞N a power function with real exponential is well defined if
the base is positive.
𝜕𝑈(𝑊) 8
9
= (𝛼 + 𝛾𝑊) :
𝜕𝑊
𝜕 " 𝑈(𝑊) 9
8 87
= −𝛽(𝛼 + 𝛾𝑊) :
𝜕𝑊 "
9
𝐴𝑅𝐴 = ;<:% is a hyperbolic function of 𝑊
 Utility
Parameters ARA RRA
𝑈(𝑊)
1 1 89%
𝛾 = 0, 𝛼 = 1 − 𝑒 𝛽 𝛽𝑊
𝛽 𝛽
CARA CARA IRRA
exponential
𝑊 789 − 1 𝛽 1
𝛾 = 1, 𝛼 = 0
1−𝛽 𝑊 𝛽
CRRA
power DARA CRRA
𝛾 = 1, 𝛼 = 0, 𝛽 = 1 1
ln 𝑊 1
(particular case of 𝑊
logarithm CRRA
HARA) DARA
1 − (𝛼 − 𝛽𝑊)" 1 𝛽𝑊
𝛾 = −𝛽
2𝛽 𝛼 − 𝛽𝑊 𝛼 − 𝛽𝑊
Quadratic not used
quadratic IARA IRRA

The only parameter that can be either positive or negative is 𝛼:

- If 𝛼 < 0, there exist a positive amount of subsistence wealth below which agents cannot
(%8%# )$%& 87
survive (𝑊= ) then 𝑈(𝑊) = 789
with 𝛾 = 1
- If 𝛼 > 0, then the wealth is allowed to be lower than 0, which mean that an agent is
allowed to borrow money and be indebted during a period of time.
INADA conditions:
1. 𝑈(0) = 0 any utility function can be modified for satisfying this condition 𝑉(𝑊) =
𝑈(𝑊) − 𝑈(0)
2. 𝑈(𝑊) ∈ 𝐶 7 (continuously differentiable)
3. 𝑈 ! (𝑊) > 0 (increasing function)
4. 𝑈 !! (𝑊) < 0 (concave function, the agent is risk averse)
5. lim 𝑈 ! (𝑊) = +∞ (with 0 health any even infinitesimal increment gives infinite increase
>→=
of utility)
6. lim 𝑈 ! (𝑊) = 0 (when having an infinite wealth, any increase in wealth does not
>→<?
changes the utility level)
% $%&
Nb. The only utility function compatible con the INADA conditions is 𝑈(𝑊) = 789
(it has
constant relative risk aversion, 𝑅𝑅𝐴 = 𝛽).
Compute the optimal portfolio:
1. Substitute the return values in 𝔼0 [𝑈(𝑊0<7 )] = 𝔼0 T𝑈U𝑊0 (1 + 𝑟) + 𝛼(𝜇 − 𝑟)XY
2. Calculate the expected value 𝔼0 [𝑈(𝑊0<7 )] = 𝑈U𝑊0 (1 + 𝑟) + 𝛼(𝜇7 − 𝑟)X ∗ 𝑝7 +
𝑈U𝑊0 (1 + 𝑟) + 𝛼(𝜇" − 𝑟)X ∗ 𝑝" in case of a lottery 𝔼0 [𝑈(𝑊0<7 )] = 𝑈(𝑊 + 𝑥) ∗ 𝑝7 +
𝑈(𝑊0 − 𝑥) ∗ 𝑝" where 𝑥 is the amount of money invested in the lottery; in case of no
insurance 𝔼0 [𝑈(𝑊0<7 )] = 𝑈(𝑊0 ) ∗ 𝑝7 + 𝑈(0) ∗ 𝑝" , in case of insurance 𝔼0 [𝑈(𝑊0<7 )] =
𝑈(𝑊0 − 𝛼) ∗ 𝑝7 + 𝑈(𝑊0 − 𝛼) ∗ 𝑝" , so I insure only if 𝔼0 [𝑈(𝐾 − 𝛼)] ≥ 𝑈(𝐾) ∗ 𝑝7 + 𝑈(0) ∗ 𝑝"
If we define:
𝑈(𝑥) − 𝑈(0)
𝑉(𝑥) =
𝑈(𝐾) − 𝑈(0)
We get:
𝑈(0) − 𝑈(0)
𝑉(0) = =0
𝑈(𝐾) − 𝑈(0)
𝑈(𝐾) − 𝑈(0)
𝑉(𝐾) = =1
𝑈(𝐾) − 𝑈(0)
𝑈(𝐾 − 𝛼) − 𝑈(0)
𝑉(𝐾 − 𝛼) =
𝑈(𝐾) − 𝑈(0)
 Thus we can conclude that an investor is willing to insure if
𝑉(𝐾 − 𝛼) = 𝑉(𝐾) ∗ 𝑝7 + 𝑉(0)𝑝"
If 𝑝" = 1 − 𝑝7 and 𝑝7 = 𝑝 then:
𝑉(𝐾 − 𝛼) ≥ 𝑝
Since the function 𝑉 is monotonic and increasing, it can be inverted:
𝛼 ≤ 𝐾 − 𝑉 87 (𝑝)
When 𝑝 increases the amount 𝛼 the investor is willing to pay deceases. (if 𝑉 is
% $%&
increasing also its inverse is). If we consider a function like 𝑈(𝑊) = 789
, the function
'$%& $
$%& % 789
𝑉(𝑥) is 𝑉(𝑥) = ($%&
= K@ N whose inverse is 𝑉 87 (𝑝) = 𝐾𝑝$%& . Now we are able to
$%&
$
;
compute the percentage of investment that agent chose to insure: @ ≤ 1 − 𝑝$%& .
;
INADA conditions allows us to conclude that the insured percentage @ is a decreasing
function of 𝑝 and its concavity depends on 𝛽. When 𝛽 = 0 the agent is risk neutral
(utility linear), in order to insure against a risk which happens with probability 1 − 𝑝
he is willing to pay exactly 1 − 𝑝 percentage of the insured investment. Instead when
𝛽 > 0 the percentage he is willing to insure is greater than 1 − 𝑝. When 𝛽 goes toward 1
;
the agent is infinitely risk averse and is willing to fully insured his investment @ = 1.
3𝔼 [4(% )]
3. Calculate and solve for 𝛼 ∗ First Order Condition ) 3; )*$ = 0
4. Approssimated solution:
𝑈(𝔼0 [𝑊0 ] − 𝜒) = 𝔼0 [𝑈(𝑊0 )]

max 𝑈U𝑊0 (1 + 𝑟) + 𝛼𝔼0 [𝜇 − 𝑟] − 𝜒(𝛼)X

;
FOC is:
𝜕𝜒(𝛼)
𝑈 ! U𝑊0 (1 + 𝑟) + 𝛼 ∗ 𝔼0 [𝜇 − 𝑟] − 𝜒(𝛼 ∗ )X _𝔼0 [𝜇 − 𝑟] − `=0
𝜕𝛼 ∗
3E(;)
From which we have that 3;∗ = 𝔼0 [𝜇 − 𝑟]: the change in the certain equivalent due to the
change in portfolio allocation must coincide with the expected excess return. For small risk we
#$#
;<<=<<>
7 4 "" (𝔼[%)*$ ])
have that 𝜒 = − 𝕍0 [𝜇 − 𝑟 ], in our case with 𝑊0<7 = 𝑊0 (1 + 𝑟) + 𝛼𝔼0 [𝜇 − 𝑟]
" 4 " (𝔼[%)*$ ])
#$#
;<
!! <<<=< <<<>
1𝑈 U𝑊0 (1 + 𝑟 )X "
𝜒=− 𝛼 𝕍0 [𝜇 − 𝑟 ]
2 𝑈 ! U𝑊0 (1 + 𝑟)X
7 3E(;)
For small risk 𝔼0 [𝜇 − 𝑟] ≈ 0 we have 𝜒 = − " 𝐴𝑅𝐴U𝑊0 (1 + 𝑟)X𝛼 " 𝕍0 [𝜇 − 𝑟 ] and so 3;∗ =
𝐴𝑅𝐴U𝑊0 (1 + 𝑟)X𝛼 ∗ 𝕍0 [𝜇 − 𝑟], if we substitute the FOC we finally obtain:
𝐴𝑅𝐴U𝑊0 (1 + 𝑟)X𝛼 ∗ 𝕍0 [𝜇 − 𝑟] = 𝔼0 [𝜇 − 𝑟]
1 𝔼0 [𝜇] − 𝑟
𝛼∗ ≈
𝐴𝑅𝐴U𝑊0 (1 + 𝑟)X 𝕍0 [𝜇]
Where 𝔼0 [𝜇] = 𝜇7 ∗ 𝑝7 + 𝜇" ∗ 𝑝" and 𝕍0 [𝜇] = (𝜇7 − 𝔼0 [𝜇 ])" ∗ 𝑝7 + (𝜇" − 𝔼0 [𝜇])" ∗ 𝑝"
The optimal portfolio:
- Positively depends on the expected excess returns
- Negatively depends on the variance of the excess return
- Negatively depends on the risk aversion index
Asset Pricing formula

. G
;<<=<
𝐺0<7 −<>
𝐺0 𝑈 ! (𝑊0<7 ) ;< <=<
𝑆0<7 −<>
𝑆0 𝑈 ! (𝑊0<7 ) 𝑆0<7 𝑈 ! (𝑊0<7 )
= 𝔼0 b d = 𝔼 0 e f − 𝔼 0 e f
𝐺0 𝔼0 [𝑈 ! (𝑊0<7 )] 𝑆0 𝔼0 [𝑈 ! (𝑊0<7 )] 𝑆0 𝔼0 [𝑈 ! (𝑊0<7 )]

𝑈 ! (𝑊0<7 ) 𝑆0<7
= 𝔼0 e f−1
𝔼0 [𝑈 ! (𝑊0<7 )] 𝑆0
So
7 7
⎡ 7<. ⎤ ⎡ 7<. ⎤
⎢ 𝑈 ! (𝑊
0<7 )
j𝐺0 ⎥ ⎢ j𝐺0 ⎥
𝑆0 = 𝔼0 ⎢ 𝑆 ⎥ = 𝔼 ⎢𝑚 𝑆
𝔼0 [𝑈 ! (𝑊0<7 )] 0<7
𝐺0<7 0 0<7 0<7
𝐺0<7 ⎥
⎢ ⎥ ⎢ ⎥
⎣ ⎦ ⎣ ⎦
If 𝑆0<7 = 𝑊0<7
𝑈 ! (𝑆0<7 ) 𝑆0<7 𝑆0<7 𝑆0<7
𝑆0 = 𝔼0 e f = 𝔼 0 o p 𝔼 0 [ 𝑚 0<7 ] + ℂ 0 o𝑚 0<7 , p
𝔼0 [𝑈 ! (𝑆0<7 )] 1 + 𝑟 1+𝑟 1+𝑟
𝑆0<7 1
= 𝔼0 o p 𝔼0 [𝑚0<7 ] + ℂ [𝑚 , 𝑆 ]
1+𝑟 1 + 𝑟 0 0<7 0<7
𝑈 ! (𝑆0<7 ) ℂ0 [𝑈 ! (𝑆0<7 ), 𝑆0<7 ]
[ ]
ℂ0 𝑚0<7 , 𝑆0<7 = ℂ0 e ,𝑆 f =
𝔼0 [𝑈 ! (𝑆0<7 )] 0<7 𝔼0 [𝑈 ! (𝑆0<7 )]
Since we want the utility function to be concave (for dealing with a risk averse investor)
ℂ0 [𝑚0<7 , 𝑆0<7 ] < 0. If an investor is risk indifferent 𝑈 !! (𝑆0<7 ) = 0, the covariance is 0. Because
H)*$
the covariance is negative, we can conclude that 𝑆0 < 𝔼0 r 7<. s. The higher the risk aversion is
the lower the price 𝑆0 because a higher risk aversion means that the marginal utility
decreases at a higher rate.
𝔼0 [𝑈 ! (𝑊0<7 )] = 𝑈 ! (𝑊0<7 ) ∗ 𝑝7 + 𝑈 ! (𝑊0<7 ) ∗ 𝑝"
I 7
Where 𝑆0<7 = 𝑆0 (1 + 𝜇) and I ) = 7<. is a discount factor.
)*$
4 " (%)*$ )
∗ 𝑝7
4 " (%)*$ ) 4 (%)*$ )∗J$ <4 " (%)*$ )∗J!
"
Where 𝑚0<7 = 𝔼) [4 " (%)*$ )]
=ℚ=u 4 " (%)*$ )
v is a martingale (called price kernel
4 " (%)*$ )∗J$ <4 " (%)*$ )∗J!
∗ 𝑝"
or risk neutral probability) since 𝑚0 = 1 and 𝔼0 [𝑚0<7 ] = 1 and so 𝑚0 = 𝔼0 [𝑚0<7 ], and 𝔼ℚ
0 [𝜇 ] =
4 " (%)*$ ) 4 " (%)*$ )
𝑟 = 𝜇7 ∗ 4 "(% "
∗ 𝑝7 + 𝜇" ∗ 4 " (% " (%
∗ 𝑝"
)*$ )∗J$ <4 (%)*$ )∗J! )*$ )∗J$ <4 )*$ )∗J!
When an agent is risk neutral, his utility function is linear, the second derivative of the utility
function is zero and the first derivative is constant 𝑈 ! (𝑊0<7 ) = 𝑘, thus the new probability is
defined as:
𝑈 ! (𝑊0<7 ) 𝑘
𝑑ℚ = 𝑑ℙ = 𝑑ℙ = 𝑑ℙ
𝔼0 [𝑈 ! (𝑊0<7 )] 𝔼0 [𝑘]
This means that any risk neutral agent will evaluate a risky asset under the original
probability ℙ:

𝑆0<7
𝑆0 = 𝔼0 o p
1+𝑟
In general equilibrium we assume 𝑆0 = 𝑊0

An economy is formed by two agents and two goods… Find the equilibrium.
; 9
𝑈# (𝑥7 , 𝑥" ) = 𝑥7# 𝑥"#
𝛼 measures the preference for good 1 and 𝛽 measures the preference for good 2.
1. Maximize the utility function subject to 𝑝7 𝑥7# + 𝑝" 𝑥"# = 𝜔7# 𝑝7 + 𝜔"# 𝑝"
2. Consider the Lagrangian function ℒ = 𝑈# + 𝜆(𝜔7# 𝑝7 + 𝜔"# 𝑝" − 𝑝7 𝑥7# − 𝑝" 𝑥"# )
3ℒ 3ℒ 3ℒ J
3. Calculate FOC 3M = 0 and 3M = 0 and 3N = 0 find J$ and then 𝑥"#
$, !, !
∗ ∗
4. For finding 𝑥7# and 𝑥"# plug the condition in the budget constraint
5. Do the same for agent B
6. The equilibrium condition is
∗ ∗
𝑥7# + 𝑥7O = 𝜔7# + 𝜔7O
∗ ∗
𝑥"# + 𝑥"O = 𝜔"# + 𝜔"O
J! J
7. Compute J optimal, if the numéraire of the economy is the first good. Compute J$
$ !
optimal, if the numéraire of the economy is the second good.
8. Comment what happened if one of the two prices increases.
9. If you want to study the behavior of the function with respect of one parameter,
-
3P $ Q
-
calculate 3;! .
Marginal rate of substitution
𝜕𝑈(𝑥, 𝑦) 𝜕𝑈(𝑥, 𝑦)
𝑑𝑈(𝑥, 𝑦) = 𝑑𝑥 + 𝑑𝑦
𝜕𝑥 𝜕𝑦
The exact ratio between the change in 𝑥 and the change in 𝑦 wich makes 𝑑𝑈(𝑥, 𝑦) = 0 is given
./(1,3)
+M
by +R = − ./(1,3)
.1
that is the marginal rate of substitution.
.3
Dynamic maximization problem
? (𝑐 ?
− 𝑐W )789 8X0
0
max | 𝑒 𝑑𝑡 + 𝜆 _𝑊= − | 𝑐0 𝑒 8.0 𝑑𝑡`
{-) } 0∈[=,<?[ = 1−𝛽 =
1. Consider the Lagrangian function ℒ = 𝑓𝑢𝑛𝑐𝑡𝑖𝑜𝑛 + 𝜆(𝑊= − 𝑓𝑢𝑛𝑐)
3ℒ 3ℒ
2. 3Y = 0 and 3N = 0
)
3. Compare the integral for any time 𝑐0∗ = argument of the FOC integral without
?
4. The constraint at any time is 𝑊0 = ∫0 𝑐Z∗ 𝑒 8.(Z80) 𝑑𝑠
? , ? ,
5. Note that ∫0 𝑘𝑒 8.(Z80) 𝑑𝑠 = .
and that ∫0 𝑘𝑒 8X(Z80) 𝑑𝑠 = X
6. Calculate the value of 𝜆
7. Calculate the value of 𝑐0∗