Expected Utility Theory

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Expected Utility Theory

© All Rights Reserved

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Introduction

• we have talked about individual decision making in

the absence of uncertainty

• in reality, we usually make decision under uncertainty

• example:

1. uncertainty from product quality (second-hand

vehicle)

2. uncertainty in dealing with others

-> often the outcome depends on what others do

3. purchase of financial assets (stocks and bonds)

whose return is contingent on which state is realized.

This is the essence of Financial Economics

2

2 Goals

1) Individual maximizes their expected Utility

0.4 10

E(W) = 0.4(10) + 0.6(2) = 5.2

Asset i E[U(W)] = 0.4U(10) + 0.6U(2) = ?

0.6 2

0.3 9 Prefer the one with higher E[U(W)]

Asset j E(W) = 0.3(9) + 0.7(4) = 5.5

0.7 4

E[U(W)] = 0.3U(9) + 0.7U(4) = ?

y C2 Return

x C1 Risk 3

Probability

• probability of an event occurring is the relative

frequency with which the event occurs

• if αi = the probability of event i occurring and there

are n possible events (states) then

• 1. αi > 0, i = 1…n

• 2. ‘i=1αi = 1

n

• X1, X2, X3,...,Xn with corresponding probabilities

• α1, α2, α3,...,αn , respectively (mutually exclusive

and exhaustive)

• then the expected value of this lottery is

• E(X) = α1X1 + α2X2 + α3X3 + ... + αnXn

• E(X) = αiXi

n

‘i=1

4

Example 1

• Gamble (X) flip of a coin

• if heads, you receive $1 X1 = +1

• if tails, you pay $1 X2 = -1

• E(X) = (0.5) (1) + (0.5) (-1) = 0

break-even

5

Example 2

• Gamble (X) flip of a coin

• if heads, you receive $10 X1 = +10

• if tails, you pay $1 X2 = -1

• if you play this game many times, you will be a big winner

• How much would you pay to play this game:

• perhaps as much as a $4.50

• But of course the answer depends upon your preference to risk

6

Fair Gambles

• if

the cost to play = expected value of

these gambles the outcome

1. individuals may agree to flip a coin for small amounts of money,

but usually refuse to bet large sums of money

unfair games (Lotto 649, where cost = $1, but E(X) < 1)

- but will avoid paying a lot

7

St. Petersburg Paradox

• Gamble (X):

• A coin is flipped until a head appears You receive $2n where n is the

flip on which the head occurred

• prob: α1 = 1/2 α2 = 1/4 α3 = 1/8 ... αn = 1/2n

1 i

E(X) = i xi 2i

2

i 1

1

Paradox: no one would pay an “actuarially fair” price to play this game

(no one would even pay close to the fair price)

8

Explaining the St. Petersburg Paradox

• this paradox arises because individuals do not make

decisions based purely on wealth, but rather on the utility of

their expected wealth

• if we can show that the marginal utility of wealth declines

as we get more wealth, then we can show that the expected

value of a game is finite

• Assume U(X) = ln(X) U'(X)=1/x > 0 MU positive

• U"(X)=-1/x2 < 0 Diminishing MU

• E(U(W)) = E(‘i=1αi U(Xi)) = ( α‘i=1i ln(Xi)) = 1.39 <

utility to play this gamble

9

Expected Utility Theory

• Objective: to develop a theory of rational decision-making under

uncertainty with the minimum sets of reasonable assumptions possible

• the following five axioms of cardinal utility provide the minimum set

of conditions for consistent and rational behaviour

(reasonable)

thousands of alternatives

(hard)

10

5 Axioms of Choice under uncertainty

A1.Comparability (also known as completeness).

For the entire set of uncertain alternatives, an individual can say

either that

either x is preferred to outcome y (x > y)

or y is preferred to x (y > x)

or indifferent between x and y (x ~ y).

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).

11

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 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 axiom of strong independence.

12

5 Axioms of Choice under uncertainty

A4.Measurability. (CARDINAL UTILITY)

If outcome y is less preferred than x (y < x) but more than z (y > z),

[1] y and

[2] A gamble between x with probability α

z with probability (1-α).

In Maths,

if x > y > z or x > y > z ,

then there exists a unique α such that y ~ G(x,z:α)

13

5 Axioms of Choice under uncertainty

A5.Ranking. (CARDINAL UTILITY)

z and we can establish gambles such that an individual is

indifferent between y and a gamble between x (with probability α1)

and z, while also indifferent between u and a second gamble, this

time between x (with probability α2) and z, then if α1 is greater

than α2, y is preferred to u.

then it follows that if α1 > α2 then y > u,

or if α1 = α2, then y ~ u

14

One more assumption

• People are greedy, prefer more wealth than

less.

• The 5 axioms and this assumption is all we

need in order to develop a expected utility

theorem and actually apply the rule of

max E[U(W)] = max ∑iαiU(Wi)

15

Utility Functions

• Utility functions must have 2 properties

alternatives:

• Deriving Expected utility theorem, one of the most elegant derivations

in Economics, is tough. Don’t worry about a formal derivation. Just

apply it.

• Remark:

Utility functions are unique to individuals

- there is no way to compare one individual's utility function with

another individual's utility

- interpersonal comparisons of utility are impossible

16

if we give 2 people $1,000 there is no way to determine who is happier

One more element: Risk Aversion

• Consider the following gamble:

• Prospect a prob = α G(a,b:α)

• prospect b prob = 1-α

certainty, or will we prefer the gamble itself?

• 10% chance of winning $100

• 90% chance of winning $0 E(gamble) = $10

• would you prefer the $10 for sure or would you prefer the gamble?

if indifferent to the options, risk neutral

if prefer the expected value over the gamble, risk averse 17

Preferences to Risk

U(W) U(W) U(W)

U(b)

U(b)

U(b) U(a)

U(a)

U(a)

a b W a b W a b W

Risk Preferring Risk Neutral Risk Aversion

U'(W) > 0 U'(W) > 0 U'(W) > 0

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

18

The Utility Function

U(W)

3.40

3.00

U'(W) > 0

U''(W) < 0

1.61

U'(W) = 1/w

U''(W) = - 1/W2

MU positive

But diminishing

0 W

1 5 10 20 30 19

U[E(W)] and E[U(W)]

• U[(E(W)] is the utility associated with the known

level of expected wealth (although there is

uncertainty around what the level of wealth will

be, there is no such uncertainty about its expected

value)

• E[U(W)] is the expected utility of wealth is utility

associated with level of wealth that may obtain

• The relationship between U[E(W)] and E[U(W)] is

very important

20

Expected Utility

• Assume that the utility function is natural logs: U(W) = ln(W)

• Then MU(W) is decreasing

• U(W) = ln(W)

• U'(W)=1/W

• MU>0

• MU''(W) < 0 => MU diminishing

20% chance of winning $30

= (0.8)*(1.61) + (0.2)*(3.40)

= 1.97

21

Therefore, U[(E(W)] > E[U(W)] -- uncertainty reduces utility

The Markowitz Premium

U(W)

3.40

U(W) = ln(W)

U[E(W)] = 2.30

U[E(W)] = U(10) = 2.30

E[U(W)]

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

= 0.8*1.61 + 0.2*3.40

1.61 = 1.97

Therefore, U[E(W)] > E[U(W)]

Uncertainty reduces utility

2.83

That is, this individual will take

7.17 with certainty rather than

the uncertainty around the gamble

0 W

1 5 CE

= 7.17 10 30 22

The Certainty Equivalent

• The Expected wealth is 10

• The E[U(W)] = 1.97

• How much would this individual take with

certainty and be indifferent the gamble

• Ln(CE) = 1.97

• Exp(Ln(CE)) = CE = 7.17

• This individual would take 7.17 with certainty

rather than the gamble with expected payoff of 10

• The difference, (10 – 7.17 ) = 2.83, can be viewed

as a risk premium – an amount that would be paid

to avoid risk

23

The Risk Premium

• Risk Premium:

– the amount that the individual is willing to give up in order to avoid the

gamble

80% change of winning $5

20% chance of winning $30

E(W) = (.80)*(5) + (0.2)*(30) = $10

Suppose the individual has the choice now between the gamble and the

expected value of the gamble

E[U[W)] = 1.97

Certainty equivalent = $7.17

Investor would be willing to pay a maximum of $2.83 to avoid the gamble

($10 - $7.17) ie will pay an insurance premium of $2.83.

THIS IS CALLED THE MARKOWITZ PREMIUM

24

The Risk Premium

an individual's level of wealth the

Risk = expected - individual would accept

Premium wealth,given he with certainty if the

plays the gamble were removed (ie

gamble the certainty equivalent)

In general,

if U[E(W)] > E[U(W)] then risk averse individual (RP > 0)

if U[E(W)] = E[U(W)] then risk neutral individual (RP = 0)

if U[E(W)] < E[U(W)] then risk loving individual (RP < 0)

risk neutrality occurs when the utility function is linear

risk loving occurs when the utility function is convex

25

The Arrow-Pratt Premium

• Risk Averse Investors

• assume that utility functions are strictly concave and increasing

• Individuals always prefer more to less (MU > 0)

• Marginal utility of wealth decreases as wealth increases

W = current wealth

gamble Z and the gamble has a zero expected value

E(Z) = 0

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?

26

The Arrow-Pratt Premium

The risk premium can be defined as the value that satisfies the following

equation:

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

for the risk premium (W,Z)

27

Absolute Risk Aversion

• Arrow-Pratt Measure of a Local Risk Premium (derived from (*)

above)

1 2 U (W)

= Z ( - )

2 U (W)

U (W)

ARA = -

U (W)

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 $1000 gamble may be trivial to a rich man, but non-trivial to a

poor man

28

Relative Risk Aversion

• Constant RRA => An individual will have constant risk aversion to a

"proportional loss" of wealth, even though the absolute loss increases

as wealth does

• Define RRA as a measure of Relative Risk Aversion

U (W)

RRA = - W *

U (W)

29

Quadratic Utility

Quadratic Utility - widely used in the academic literature

U(W) = a W - b W2

-U"(W) 2b

ARA = --------- = ---------

U'(W) a -2bW

d(ARA) increasing ARA

------- > 0 and increasing RRA

dW

ie an individual with increasing RRA would

2b become more averse to a given percentage

RRA = --------- loss in W as W increases

a/W - 2b

- not intuitive

d(RRA)

------- > 0

dW 30

The Empirical Evidence

• Empirical evidence (Friend and Blume (1975)) indicates that

individuals have decreasing ARA and constant RRA = 2

Friend and Blume (1975)

31

An Example

• U=ln(W) W = $20,000

• G(10,-10: 50) 50% will win 10, 50% will

lose 10

• What is the risk premium associated with

this gamble?

• Calculate this premium using both the

Markowitz and Arrow-Pratt Approaches

32

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)

33

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

34

Markowitz Approach

E(U(W))

= 9.903487

35

CE

Differences in two approaches

• Markowitz premium is an exact measures whereas

the AP measure is approximate

• AP assumes symmetry payoffs across good or bad

states, as well as relatively small payoff changes.

• It is not always easy or even possible to invert a

utility function, in which case it is easier to

calculate the AP measure

• The accuracy of the AP measures decreases in the

size of the gamble and its asymmetry

36

Mean & Variance as choice variables

• With 5 axioms, prefer more to less, we

have Expected utility theorem

• With risk-aversion assumption, we

solve St. Petersburg’s paradox Return

• With returns of risky assets being

jointly normally distributed, we can

draw indifference curves on the plane

of return (E(r)) and risk (var(r) or

standard deviation of r) as the right

diagram Risk

choice variables investors concern

about in order to max their E[U(w)]

37

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