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Chapter 1

Utility Theory
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This chapter derives asset prices in a one-period model. We derive

a version of the Capital Asset Pricing Model (CAPM) using a com-
plete market, state-contingent claims approach. We define the for-
ward pricing kernel and then use the assumption of joint normality
of the cash flows and Stein’s lemma to establish the CAPM. We then
derive the pricing kernel in an equilibrium representative investor
model. But first, we need to understand a few properties of utility
function.
A common utility function we use in economics/finance is the
power utility. Its functional form is:
W 1−γ − 1 W 1−γ
U (W ) = 1−γ
or U (W ) = 1−γ
with γ = 1.

This may seem a strange choice for a utility functional form, but it
is actually a very clever one. The Arrow–Pratt measures of (absolute
and relative) risk aversion (RA) are
U  (W )
ARA = −
U  (W )
and
U  (W )
RRA = − W.
U  (W )

1
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By the assumption of a risk averse investor, U (W ) is increasing

and strictly concave

U  (W ) > 0, U  (W ) < 0 and A(W ) > 0.


The inverse of RA − UU(W )
(W ) is also known as risk tolerance.
1
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Using the power utility function, we get U  (W ) = W −γ and

U (W ) = −γW −γ−1 . Therefore, the Arrow–Pratt measure of Rela-


tive Risk Aversion (RRA) under power utility is RRA = γ. If γ > 0,

then the agent is risk averse. If γ < 0, we would call her risk seeker
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(or lover). To satisfy the second common assumption of concavity, we

need γ > 0. In other words, power utility function with γ > 0 refers
to an investor with RRA that is independent of her level of wealth,
which is why it is also called the constant RRA utility function.
In the case where γ = 1 we get a special utility function, called the
logarithmic function, U (W ) = log(W ). You can see that by taking
the limit
W 1−γ − 1
lim U (W ) = lim
γ→1 γ→1 1−γ
(−1)W 1−γ log(W )
= lim
γ→1 −1
= log(W ),

after applying l’ Hôpital’s rule. Essentially, log utility function is a

CRRA utility function with RRA = 1.
Another commonly used utility function is the negative exponen-
tial utility
exp(−ηW )
U (W ) = − , η = 0,
η

U (W ) = exp(−ηW ),

U (W ) = −η exp(−ηW ),

1
Indeed, with the advances of research, we now know that these lower order of
risk preference measures are not sufficient in distinguishing risks represented by
higher moments of the risky return distribution. But we will confine our scope
here to the classical analyses only omitting e.g. skewness preference.
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Utility Theory 3

so ARA = η and RRA = ηW . This is why this utility function is

called the Constant Absolute Relative Risk Aversion (CARA) util-
ity function. For an investor to be risk averse, we would require
η > 0.
Finally, a linear utility function of the form U (W ) = a + bW ,
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corresponds to a risk-neutral investor. Why? Because U  (W ) = b and

U  (W ) = 0. In other words, the function is not concave (obviously,
since it is linear in W ) and the Arrow–Pratt measures of risk aversion
are ARA = RRA = 0.
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1.1 Risk Aversion and Certainty Equivalent

For a given utility function U (·) and uncertain terminal wealth W ,
we can write W in terms of its certainty equivalent Wc as follows:
Wc ≡ U −1 {E[U (W )]}. (1.1)
The term “risk averse” as applied to investors with strictly con-
cave utility functions is descriptive in the sense that the certainty-
equivalent end-of-period wealth is always less than the expected value
E(W ) of the associated portfolio for all such investors. The proof
follows from Jensen’s inequality: if U is strictly concave, then
E[U (W )] < U [E(W )],
Wc < E[W ].
The smaller the Wc , the more risk averse is the investor.
U(W)

U(E[W])

E[U(W)]

W
WC E[W]
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4 Advanced Finance Theories

An investor is said to be more risk averse than a second investor

if, for every portfolio, the certainty-equivalent end-of-period wealth
for the first investor is less than or equal to the certainty equivalent
end-of-period wealth associated with the same portfolio for the sec-
ond investor. This statement is always true disregarding the shape
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of the risky return distribution and the order of risk preference.

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