THEORY

Bernoulli

- a lottery should be valued according to the exp. utility that it provides, rather than according to the
mathematical expectation

- the concavity of the relationship between wealth and utility implies decreasing marginal utility

- investors with concave utility function would support risk diversification

Compound lottery

- more general variant of lottery allows the outcomes themselves to be simple lotteries

- for any compound lottery, we can calculate a corresponding reduced lottery L as the simple lottery
that generates the same ultimate distribution over outcomes

Principle of invariance

- for any risky alternative, only the reduced lottery over the final outcomes is of relevance to the
decision maker

Continuity Axiom

. if L1 > L3 > L2, then we can show L3 through L1 and L2

Independence Axiom

- if we mix 2 lotteries with the third one, then the preference ordering of the two resulting mixtures
doesn’t depend on the particular lottery used

- the choice between options only depends on states in which they yield different outcomes

- it allows us to collect compound lotteries to a single lottery

ABSOLUTE RISK AVERSION

- comparison of attitudes toward risky projects whose outcomes are absolute gains or losses from
current wealth
Risk aversion

- decision maker prefers lotteries which have similar outcomes in both states over outcomes that have a
high outcome in one state but only a small outcome in other state

INSURANCE – CRITIQUE

1) Damage probabilities are exogenously determined

- they can be influenced by the insured person – MORAL HAZARD

- higher costs may also apply when the insured person claims to have lower risk than true – ADVERSE S.

2) Real behavior is in conflict with exp.utility maximization

- behavioral finance is used to study deviations from perfectly rational behavior

CERTAINTY EQUIVALENT

- certain outcome such that we are indifferent between accepting the gamble or just having the certain
amount C

- this point C has the utility level u(C) which corresponds to the exp.utility when we accept the gamble

- since C is smaller than W, this means we are willing to give up some of our expected wealth in order to
avoid accepting the gamble --- risk averse behavior

FSD

- A is FSD over B if for every payoff the probability of A yielding at least this payoff is larger or equal to
the probability of B yielding this outcome

- any change in risk that is generated by transfer of probability mass from high wealth states to low
wealth states is said to be FSD-deteriorating

- if we have 2 individuals with strictly monotonically increasing utility functions and their preferences
according to 2 lotteries are different, then there can’t be FSD
MPS

- change from one probability distribution A to another probability distribution B, where B is formed by
spreading out one or more portions of A’s probability density function or probability mass function
while leaving the mean unchanged

- concept of MPS provides a stochastic ordering of equal-mean gambles (prob.distr.) according to their
degree of risk

- if B is MPS of A, then A is SSD over B

- whenewer there is SSD, the dominated distribution is the MPS of the dominating distribution

2) Explain and discuss the main ideas (4) underlying prospect theory! Explain property of subcertainty.

- always consider fin. outcomes as gains and losses RATHER than states and wealth

- framing

- mental accounting

- S-shaped

- method of cancellation

4) may principles of rational choice be violated by i) prospect theory and ii) cumulative prospect theory?
explain! discuss differences between PT and CPT!

GRAPHS

-indifference curves of the mean-variance utility function

- quadratic utility function

----how graphs relate to each other