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Shih En Lu
p1 u1 + p2 u2 + ... + pn un
E [L] CE (L)
p
Exercise: You have utility over wealth u (w ) = w and start with
$50. Consider a bet with probability 0.5 of winning $14, and
probability 0.5 of losing $14, so that the lottery is $64 with prob. 0.5,
and $36 with prob. 0.5. Find the EV of the lottery and of the bet.
Find your EU, CE and risk premium for the lottery. Would you take
the bet?
Constant CARA implies that whether you’d take a bet doesn’t depend
on your initial wealth.
Not very realistic! CARA should probably decrease as wealth
increases.
The coe¢ cient of relative risk-aversion (CRRA) at wealth w is
de…ned as:
u 00 (w )
w
u 0 (w )
Exercise: show that u (w ) = w σ has constant CRRA for any
σ 2 (0, 1), and …nd the CRRA. Do the same for u (w ) = w σ for
σ < 0, and u (w ) = ln(w ).
Constant-CRRA utility is widely used in …nancial economics.
Suppose that when a loss occurs, the insurance policy pays sL. (So
s = 0 means no insurance, and s = 1 means full insurance.)
Suppose π = sK : it would cost Al K to full insure himself, but he
can also choose to insure himself partially (s < 1) or even overinsure
(s > 1).
Al chooses s to maximize
pu (w0 sK L + sL) + (1 p )u (w0 sK ).
F.o.c.: p (L K )u 0 (wacc )
= (1 p )Ku 0 (wno acc )
When K = pL, we say that the premium is actuarially fair: it is
equal to the expected cost to the insurance …rm. What happens then?
What if K > pL? K < pL?