Theory of Choice under Uncertainty

Why Care about Uncertainty?

Simple answer: Because almost every decision we make
involves uncertainty.
• Examples:
– Uncertainty from product quality. (e.g., used vehicle, order
food before eating, any durable goods consumption)
– Uncertainty in dealing with others. (i.e., your payoffs
depend on others’ actions, e.g., competition among firms,
driving, etc.)
– Purchase of risky assets (i.e., risk in the sense that the
payoffs of assets depends on what happen in the future, e.g.,
stocks, bonds, etc.)
This is the essence of Financial Economics
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 The Objective
• Goal: Develop a useful set of framework for
predicting investor choices under uncertainty:
– A) 5 axioms of rational choice under uncertainty
– End-Product: Expected Utility Theorem to measure utility in the
presence of risk.
– B) Assumption of non-satiation (i.e., greed)
– C) Risk-aversion
– D) Measuring the objects of choice (i.e., the assets that
investors invest) using Mean and Variance of asset
return.
– E) Mapping trade-offs between Mean and Variance that
provides indifference curves of investors.
– such trade-off reveals an investor’s degree of risk-aversion.

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 The End-Product
• By the end of this lecture, we will be able to formulate
the following diagram of individual investor’s
indifference curves.
Returns
EU2
EU1

Message: Risk

[i] For the same level of risk, everyone prefers higher returns.
[ii] For the same level of returns, everyone prefers lower risk. 4
 An Example to Motivate
Expected utility theory says:
• When payoffs in the next period are uncertain, any individual’s subjective preference
can be represented by a utility function, if his subjective preference satisfies the five
axioms.
• => “5 axioms” + “Greed” => individual’s decision-making process under uncertainty
can be described by the following problem:
Max [Expected utility of wealth] subject to constraints.
• Qs.: Suppose Rajiv’s constraint is such that the money he now has can ONLY be
allocated in one of the two assets, Asset i or Asset j, that pay off in the next period
according to the two diagrams below. What should he do?
• Answer: He chooses to hold the asset that gives him the highest expected utility of
wealth, but NOT the highest expected wealth.
0.4 Rs.10
E(W) = 0.4(10) + 0.6(2) = 5.2
Asset i E[U(W)] = 0.4U(10) + 0.6U(2) = ?
0.6 Rs.2
0.3 Rs.8 He would choose the asset that gives him highest E[U(W)]

Asset j E(W) = 0.3(8) + 0.7(3) = 4.5 5

0.7 Rs.4
E[U(W)] = 0.3U(8) + 0.7U(3) = ?
 St. Petersburg Paradox
• The ultimate question that expected utility theorem wants to address is:
“Is there a way to systematically measure the level of happiness under uncertainty?”
The St. Petersburg Paradox is an example to convinces you that the following:
“happiness under uncertainty ≠ E(W)”
“Suppose someone offers to toss a fair coin repeatedly until it comes up heads, and to pay you $1 if this
happens on the first toss, $2 if it takes two tosses to land a head, $4 if it takes three tosses, $8 if it takes
four tosses, etc. What is the largest sure gain you would be willing to forgo in order to undertake a single
play of this game?”

State (The number of tosses a head first comes up) Payoff Probability

1st toss 20=$1 ½

2nd toss 21=$2 (½)2 = ¼

3rd toss 22=$4 (½)3 = 1/8

• The table illustrates only 3 possible states, but you can construct this table infinitely.
The point is, the game’s Expected payoff (i.e, E(x)) is infinite, i.e., ∞.
• Depending on your risk-preference, you may probably pay $2, or even $10 to play
this gamble. But you are unlikely to pay $1,000 to play. The point is, probably no
one on earth would pay any amount close to the expected payoff.
• Why? Because maximizing our happiness does not imply maximizing our expected
wealth. It is really the expected utility of wealth that measures our level of
happiness.
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 Rational Decision Theory
• To develop a theory of rational decision making under uncertainty, we
impose some precise yet reasonable axioms about an individual’s behavior.

• We assume 5 axioms of cardinal utility.

– Axiom 1: Comparability (or, completeness)
– Axiom 2: Transitivity (or, consistency)
– Axiom 3: Strong independence
– Axiom 4: Measurability
– Axiom 5: Ranking

• What do these axioms of generally mean?

– all individuals are assumed to make completely rational decisions – a
reasonable task
• A statement that "I like Chevrolets more than Fords and Fords more
than Toyotas but Toyotas more than Chevrolets" is not rational.
– people are assumed to make these rational decisions among thousands
of alternatives – not a very simple task

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5 Axioms of Choice under Uncertainty
A1.Comparability (also known as completeness).
For the entire set, S, of uncertain alternatives, an individual can
say that
either outcome x is preferred to outcome y (x › y)
or y is preferred to x (y › x)
or indifferent between x and y (x ~ y).

A2.Transitivity (also known as consistency).

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).
Similarly, if an individual is indifferent between x and y and is
also indifferent between y and z, then the individual is indifferent
between x and z. If (x ~ y and y ~ z, then x ~ z).
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5 Axioms of Choice under Uncertainty
A3.Strong Independence.
Suppose we construct a gamble where the individual has a
probability α of receiving outcome x and a probability (1-α) of
receiving outcome z. This gamble is written as:
G(x,z:α)
Strong independence says that if the individual is indifferent
to x and y, then he or she will also be indifferent as to a first
gamble, set up between x with probability α and a mutually
exclusive outcome z, and a second gamble set up between y
with probability α and the same mutually exclusive outcome
z.
If x ~ y, then G(x,z:α) ~ G(y,z:α)
The choice of the third outcome z will not affect the
relationship between x and y. 9
5 Axioms of Choice under Uncertainty
A3.Strong Independence: To illustrate it, consider the following example.
❖ Let outcome x be winning a left shoe, let y be a right shoe, and let z also be
a right shoe.
❖ Imagine two gambles. The first is a 50/50 chance of winning x or z (i.e., a
left shoe or a right shoe). The second gamble is a 50/50 chance of winning y
or z (i.e., a right shoe or a right shoe).
❖ If we were originally indifferent between our choice of a left shoe (by itself)
or a right shoe (by itself), then strong independence implies that we will also
be indifferent between the two gambles we constructed.
❖ Of course, left shoes and right shoes are complementary goods, and we
would naturally prefer to have both if possible.
❖ The point of strong independence is that outcome z in the above
examples is always mutually exclusive. In the first gamble, the payoffs are
the left shoe or a right shoe but never both.

NOTE: The mutual exclusiveness of the third outcome z is critical to the

axiom of strong independence. 10
 5 Axioms of Choice under Uncertainty
A4.Measurability. (concerning about CARDINAL UTILITY)

If outcome y is less preferred than x (y ‹ x) but more than z (y › z),

then there is a unique probability α such that:

the individual will be indifferent between

[1] y and
[2] a gamble between x with probability α and
z with probability (1-α).

In Math:
if x › y > z or x > y › z ,
then there exists a unique probability α such that y ~ G(x,z:α)
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 5 Axioms of Choice under Uncertainty
A5.Ranking. (CARDINAL UTILITY)

If alternatives y and u both lie somewhere between x and z and we

can establish gambles such that an individual is indifferent
between y and a gamble between x (with probability αy) and z,
while also indifferent between u and a second gamble, this time
between x (with probability αu) and z, then if αy is greater than αu,
y is preferred to u.

If x > y > z and x>u> z

then if y ~ G(x,z:αy) and u ~ G(x,z:αu), it follows that

if αy > αu then y › u,
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or if αy = αu , then y ~ u
 Developing Utility Functions
Question: How do individuals rank various combinations of risky
alternatives?

• Use the axioms to show how preferences can be mapped into

measurable utility.

• The utility function will have two properties.

• First, it will be order preserving. In other words, if we measure
the utility of x as greater than the utility of y, i.e., U (x) > U (y),
it means that x is preferred to y (i.e., x › y ).
• Second, expected utility can be used to rank combinations of
risky alternatives. Mathematically, this means that
U[G(x, y :α)}= αU(x)+(l-α)U(y)
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Developing Utility Functions

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 Developing Utility Functions
❖ Next it is important to show that expected utility can be used to rank risky
alternatives. This is the second property of utility functions.
❖ Let us begin by establishing the elementary gambles in exactly the same
way as before.
❖ Next, consider a third alternative, z. Note that we can rely on Axiom 3
(strong independence) to say that the choice of z will not affect the
relationship between x and y.
❖ Next, by Axiom 4, there must exist a unique probability, β (z ), that would
make us indifferent as to outcome z and a gamble between x and y

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16
 Your Preference Dictates U(W)
E(U(W)) = ∑i [(Prob. of state i) x (payoffs in state i)]

• With this in mind, we do an exercise to show how your preference constructs your
unique utility function.
• Suppose I arbitrarily assign a utility of -10 to a loss of INR 1000 and ask the following
question:
– If you are faced with a gamble with prob. p of winning INR 1000, and prob. (1-p) of losing
INR 1000. What is this precise p that makes you indifferent between:
[i] taking the gamble or
[ii] getting INR 0 with certainty?
• In math, we have:
U(0) = pU(1000) + (1-p)U(-1000)
= pU(1000) + (1-p)(-10)
• Assume U(0) = 0 for yourself, and if your answer is that p = 0.6, then, U(1000) =
6.66667.
• Repeat this procedure for different payoffs, and you can work out your own utility
function.
• MESSAGE: The AXIOMS of preference is convertible to a UTILITY fn.

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 Establishing a Definition of Risk Aversion
• Having established a way of converting the axioms of preference into a utility
function, we can make use of the concept to establish definitions of risk premia
and precisely what is meant by risk aversion.
• A useful way to begin is to compare three simple utility functions that assume
that more wealth is preferred to less
• In other words, an individual’s preference is such that his utility function
exhibits marginal utility being always positive (i.e., the greed assumption), i.e.,
U'(W) > 0

Goals:
(a) Formally define what is risk-aversion.
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(b) Establish the concept of risk-premium
 Risk Aversion
• Consider the following gamble:
• Outcome a prob = α
• Outcome b prob = 1-α => G(a,b:α)

Question: Will we prefer the expected value of the gamble with certainty,
or will we prefer the gamble itself?

• E.g., consider the gamble with

• 20% chance of winning INR 30
• 80% chance of winning INR 5 => E(Payoff of Gamble) = INR 10

Question: Would you prefer the INR 10 for sure or would you prefer the gamble?
[i] if prefer the gamble, you are risk loving
[ii] if indifferent to the options, risk neutral
[iii] if prefer the expected value over the gamble, risk averse

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 Risk-Aversion as Shown in Utility Fn
Suppose U(W)=ln(W)
3.40=U(30)

Risk-averse U:
2.30=U[E(W)]
Let U(W) = ln(W)

U'(W) > 0
U''(W) < 0
1.61=U(5)

U'(W) = 1/w
U''(W) = - 1/W2

MU positive
But diminishing

0 W
1 5 10 20 30 20
 Risk-Aversion as Shown in Utility Fn
U(W)=lnW
3.40=U(30)

Risk-averse U:
2.30=U[E(W)]
Let U(W) = ln(W)

1.97=E[U(W)] E[U(W)]
=0.8U(5) + 0.2U(30)
1.61=U(5) =0.8(1.61)+0.2(3.4)
=1.97

Certainty Equivalent:
U(CE) = 1.97 = ln(CE)
CE=7.17

0 W
1 5 7.17 10 20 30 21
 U[E(W)] VS E[U(W)]
In general, following Markowitz (1959),

if U[E(W)] > E[U(W)] then risk averse individual

if U[E(W)] = E[U(W)] then risk neutral individual

if U[E(W)] < E[U(W)] then risk loving individual

risk aversion occurs when the utility function is strictly concave

risk neutrality occurs when the utility function is linear
risk loving occurs when the utility function is convex

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Certainty Equivalent and Markowitz Risk Premium
CE’s Definition: The amount of money that the individual needs to hold for certainty in
order to be indifferent from playing the gamble.
As in the example: This person is indifferent between
[i] holding INR 7.17 for certain
[ii] playing the gamble that has 80% chance with INR 5 and 20% with INR 30.

Risk premium: the difference between an individual’s expected wealth, given the
gamble, and the certainty equivalent wealth.
As in the example: This person pays a risk-premium of:
RP = E(Wealth given the Gamble) – CE
= INR 10 – INR 7.17 = INR 2.83
Meaning: Any insurance that costs less than INR 2.83 that ensures him the level of
wealth of INR 10 will be attractive to him.
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 Risk Premium vs Cost of Gamble
Risk premium: the difference between an individual’s expected wealth, given the
gamble, and the certainty equivalent wealth.
As in the example: This person pays a risk-premium of:
RP = E(Wealth given the Gamble) – CE
= INR 10 - $7.17 = INR 2.83
Meaning: Any insurance that costs less than INR 2.83 that ensures him the level of wealth
of INR 10 will be attractive to him.
Cost of gamble: The difference between an individual’s current wealth and the certainty
equivalent wealth.
e.g., Denote E(x) = E(Wealth given the Gamble), if the individual’s current wealth is:
(a) INR 10 = E(x) Cost of gamble = 10 –7.17 = INR 2.83 RP = C of Gamble
(b) INR 11 > E(x) Cost of gamble = 11 - 7.17 = INR 3.83 RP < C of Gamble
(c) INR 9.5 < E(x) Cost of gamble = 9.5 - 7.17 = INR 2.43 RP > C of Gamble
NOTE: Risk premium may or may not be the same as Cost of Gamble.
NOTE: If you are risk-averse, risk premium is always positive!!!
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 The Arrow-Pratt Premium
We can have a more solid, or mathematical, definition of premium, given that:
• Risk Averse Investors
• And that his utility functions are strictly concave and increasing

A More Specific Definition of Risk Aversion

W = Current wealth
ž = Random gamble payoffs, where E(ž) = 0, Variance of ž = σ2z
W+ ž = Wealth given gamble
E(W+ ž) = Expected Wealth given the Gamble
(W,Z) = Arrow-Pratt Premium

What risk premium (W,Z) must be added to the gamble to make the individual indifferent
between the gamble and the expected value of the gamble?

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 The Arrow-Pratt Premium
The risk premium  can be defined as the value that satisfies the following
equation:

E[U(W + ž)] = U[ W + E(ž) - ( W , ž)] (*)

LHS: RHS:
expected utility of utility of the current level of wealth
the current level plus
of wealth, given the the expected value of
gamble the gamble
less
the risk premium

We use a Taylor series expansion to (*) to derive an expression for the

risk premium (W,ž).

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 Absolute Risk Aversion
• Arrow-Pratt Measure of a Local Risk Premium (derived from (*) above)
1 2 U (W)
= Z ( - )
2 U (W)
• Define ARA as a measure of Absolute Risk Aversion
U (W)
ARA= -
U (W)

• This is a measure of absolute risk aversion because it measures risk

aversion for a given level of wealth
ARA > 0 for all risk-averse investors (U'>0, U''<0)
How does ARA change with an individual's level of wealth?
• ie. A gamble that involves $1,000 fluctuations of wealth up or down may
be trivial to Bill Gates, but non-trivial to me:

=> ARA will probably decrease as our wealth increases

i.e., ARA ↓ as W ↑
=> The willingness to take a risk of a given absolute size increases as
wealth increases
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 Relative Risk Aversion

• Define RRA as a measure of Relative Risk Aversion

U (W)
RRA= - W *
U (W)
• Constant RRA => An individual will have constant risk aversion to a
"proportional loss" of wealth, even though the absolute loss increases
as wealth does.
• That is, with a gamble with 50/50 chance of increasing your wealth by
10% or decreasing it by 10%, you are about as risk-averse to such
gamble regardless of how wealthy or how poor you are. The risk
premium, measured as a percentage of your initial wealth, will stay
constant.

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 E.g.: Quadratic Utility
Quadratic Utility - widely used in the academic literature

U(W) = a W - b W2

U'(W) = a - 2bW U"(W) = -2b

-U"(W) 2b
ARA = --------- = --------- quadratic utility exhibits
U'(W) a -2bW increasing ARA
and increasing RRA

d(ARA) i.e., an individual with increasing RRA would

------- > 0 become more averse to a given percentage
dW loss in W as W increases

2b - not intuitive: A billionaire who loses half his

RRA = --------- wealth, leaving INR 500 million, would lose
a/W - 2b more utility than a pauper who started with INR
20,000 and ended up with INR 10,000.
d(RRA)
------- > 0
dW 29
 Quick Activity
• U=ln(W) W = $20,000
• G(10,-10: 0.5)
• What is the risk premium associated with
this gamble?
• Calculate this premium using both the
Markowitz and Arrow-Pratt Approaches

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 Arrow-Pratt Measure

•  = -(1/2) 2z U''(W)/U'(W)

• 2z = 0.5*(20,010 – 20,000)2 + 0.5*(19,090 – 20,000)2 = 100
• U'(W) = (1/W) U''(W) = -1/W2
• U''(W)/U'(W) = -1/W = -1/(20,000)

•  = -(1/2) 2z U''(W)/U'(W) = -(1/2)(100)(-1/20,000) = $0.0025

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 Markowitz Approach

• E(U(W)) =  piU(Wi)
• E(U(W)) = (0.5)U(20,010) + 0.5*U(19,990)
• E(U(W)) = (0.5)ln(20,010) + 0.5*ln(19,990)
• E(U(W)) = 9.903487428
• ln(CE) = 9.903487428 → CE = 19,999.9975
• The risk premium RP = $0.0025
• Therefore, the AP and Markowitz premia are the same

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 Markowitz Approach

E(U(W))
= 9.903487

19,990 20,000 20,010

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CE
 Differences in two approaches
• Markowitz premium is an exact measures whereas
the AP measure is an approximation.
• AP is an accurate approximation if
– The gamble’s payoffs is relatively small relative to
initial wealth.
– The gamble’s payoffs is symmetric.
• The accuracy of the AP measures decreases in the
size of the gamble and its degree of asymmetry

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 Summary

• With 5 axioms, prefer more to less, we have Expected

utility theory, where preferences => Utility function.
• Assuming we are all greedy, we know every rational
investor will maximize his E[U(W)].
• Assuming returns of risky assets being jointly
normally distributed, we leave ourselves with a 2-D
diagram with mean of returns and standard deviation
of returns (i.e, mean and s.d.) as our two only Return
variables of focus
• Derive indifference curves on the plane of return and
risk as the right diagram with expected utility theory.

Risk

END-PRODUCT: Essentially, mean and standard

deviation are the choice variables investors concern about
in order to max their E[U(w)], which is given on the
indifference curves. 35