BUSI3502: Investments

Week 6: October 14th, 2021

Introduction to Utility Functions – parts of Ch 6

and Ch 6 Appendix (p.201)

Course Professor: Dr. M. Al Guindy

Utility

◼ Utility = happiness and depends on consumption

◼ More consumption increases utility (more is better
than less)
◼ The increase in utility brought about by a unit increase
in consumption is less than the last unit increase (i.e.
the first bite is always the best). Diminishing marginal
utility
◼ We punish losses more than we value gains

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Consider an experiment
I will flip a coin once and will pay you a dollar if the coin came up
tails on the first flip; the experiment will stop if it came up heads.
If you win the dollar on the first flip, though, you will be offered a
second flip where you could double your winnings if the coin
came up tails again. The game will thus continue, with the prize
doubling at each stage, until you come up heads. How much
would you be willing to pay to partake in this gamble?
❑ A lot
❑ $2
❑ $4
❑ $10

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The St. Petersburg Paradox and Expected
Utility: The Bernoulli Contribution

The payoff to the bet is as follows:

1 1 1 1
E value = 1 + 2 + 4 + 8 +⋯
2 4 8 16
◼ This is called the St. Petersburg Paradox as summarized by Bernoulli

◼ The payoff to the bet is as follows:

1 1 1 1
𝐸 𝑣𝑎𝑙𝑢𝑒 = 1 + 2 + 4 + 8 +⋯
2 4 8 16
𝐸[𝑣𝑎𝑙𝑢𝑒] = 1/2 + 1/2 + 1/2 + 1/2 + ⋯
𝐸[𝑣𝑎𝑙𝑢𝑒] =∞

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Utility Function

We need a utility function that helps us to

explain this

1 1 1 1
𝐸[𝑈] = 𝑈(1) + 𝑈(2) + 𝑈(4) + 𝑈(8) +…
2 4 8 16

𝐸[𝑈] =?

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Log-normal utility

◼ For the value to be so low we must have a "utility function"

that helps us explain this: e.g. the ln function

1 1 1 1
𝐸[𝑈] = 𝐿𝑛(1) + 𝐿𝑛(2) + 𝐿𝑛(4) + 𝐿𝑛(8) +…
2 4 8 16

◼ It turns out that this is l𝑛(4) is about what people are

willing to pay for the bet!

◼ This implies that we should look at utility instead of

payoffs

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Utility functions

◼ A utility function is a twice-differentiable function of

wealth 𝑈(𝑤) defined for 𝑤 > 0 which has the
properties:

❑ No-satiation (the first derivative 𝑈ʹ(𝑤) > 0)

❑ Risk aversion (the second derivative 𝑈ʺ(𝑤) < 0), i.e.
a concave function.

◼ A utility function measures an investor’s relative

preference for different levels of total wealth.

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Risk Aversion

◼ People care about expected "discounted"

utility, where utility is concave!
◼ Using utility functions we can quantify the
tradeoff between a "sure" payoff and a risky
payoff with the same expected value.

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Expected Utility Maximization
◼ The principle of expected utility maximization states
that a rational investor, when faced with a choice
among a set of competing feasible investment
alternatives, acts to select an investment which
maximizes her expected utility of wealth

◼ Marginal Utility measures the incremental value of

one additional “unit” of utility. Often, we observe
decreasing marginal utility.

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Risk Aversion & Utility
How do investors select between risky
investments, X, Y, and Z?

1. Comparability:
❑ It’s important to be able to compare investments
(e.g. If we prefer outcome X to Y, we are
indifferent between Y and Z, etc.)
2. Transitivity:
❑ If we prefer X to Y and prefer Y to Z, then we must
also prefer X to Z

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Risk Aversion & Utility
3. Strong Independence
Suppose we have the following:
Gamble 1 Gamble 2
Probability Outcome Probability Outcome
α X α Y
1-α Z 1-α Z

◼ If we are indifferent between X and Y then we

must also be indifferent to the gamble
G(X,Z;α) ~ G(Y,Z;α)

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Risk Aversion & Utility
4. Measurability
◼ Suppose you prefer X to Y and prefer Y to Z. Given the
gamble in 3 above, this implies that Y is somewhere
between X and Z in terms of preference. It is possible that
Y may be at a point exactly between X and Z such that you
are indifferent to either taking gamble 1 or to receiving Y for
sure. Y is referred to as the Certainty Equivalent (CE) of
the gamble. If you are indifferent, then the satisfaction you
receive from the gamble must be identical to the
satisfaction received from Y. We measure satisfaction by
utility;

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Risk Aversion & Utility
5. Ranking
Every gamble must have a certainty equivalent associated with it. For
example, suppose X is preferred to Z. Gamble 3 and gamble 4 below
will each have a certainty equivalent of Y3 and Y4, respectively.
Gamble 3 Gamble 4
Probability Outcome Probability Outcome
α3 X α4 X
1-α3 Z 1-α4 Z
If α3 > α4, then Y3 > Y4, and we can rank gambles according to
the expected utility received.

◼ Therefore:
The expected utility of a gamble is equal to the weighted average of the
utilities of the outcomes, which is equal to the expected utility of the CE!

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Utility example (part 1)
Now we can rank risky alternatives in an uncertain world!

Formally;

E{U(G(X,Z;α))} = αU(X) + (1-α)U(Z) = E{U(Y)}

Assume there is a risky gamble available to us with the following
possible outcomes: A 50/50 chance that our wealth will
increase/decrease by $1000.
The question we need to ask is:
If you are at a given level of wealth (say, $5000), then how
do you feel about an increase/decrease of $1000?

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Utility example (part 2)
If you are at a given level of wealth (say, $5000), then
how do you feel about an increase/decrease of $1000?

◼ The expected utility of wealth is equal to the utility of

taking the gamble. In other words, your new level of
utility that you expect to achieve if you take the gamble is
equal to the weighted average of the utilities of each of
the outcomes of the gamble; in other words:

~)) =  (U ( w + payoff )) + (1 −  )(U ( w − payoff ))

E (U ( w 0 0

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Utility example (part 3)
Initial wealth of $5000, 50/50 gamble will increase/decrease
our wealth by $1000.
❑ Your expected wealth = 0.5*6000+0.5*4000=5000
❑ the expected utility of your wealth is half of the utility of
outcome 1 plus half of the utility of outcome 2.

let U(w)=ln(w)
Expected utility of wealth =
E(U(W)) = 0.5*ln(6000)+0.5*ln(4000)=8.4967822
The Certainty Equivalent (CE)= 𝑒 8.4967822 = $4,898.98
Utility of expected wealth =
U(E(w))=ln(5000)=8.5171932
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Risk and Risk Aversion
❑ Using utility functions we can quantify the tradeoff
between a "sure" payoff and a risky payoff with the
same expected value.

❑ Investors are willing to consider:

◼ Risk-free assets
◼ Speculative positions with positive risk premiums

❑ Portfolio attractiveness
◼ Increases with expected return
◼ Decreases with risk

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The Utility Function

◼ Choice between expected return and risk, the latter measured

by the variance or standard deviation

◼ Quadratic utility:
𝟏 𝟐
𝑼(𝒓) = 𝑬(𝒓) − 𝑨𝝈
𝟐
❑ 𝑈 = utility
❑ 𝐸(𝑟) = expected return on the asset or portfolio
❑ 𝐴 = coefficient of risk aversion
❑ 𝜎 2 = variance of returns
❑ ½ = scaling factor

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