FINANCIAL ECONOMICS

Lecturer ： Do Duy Kien, PhD

Foreign Trade University, HCM Campus

Email ： doduykien.cs2@ftu.edu.vn

Copyright (ppt slides): Quyen Do Nguyen, PhD

Faculty of Banking and Finance
Foreign Trade University
CHAPTER 3: INVESTMENTS UNDER
UNCERTAINTY
 Main content
3

 Investment decision when risks are involved

 Optimal investment under uncertainty

 Five axioms of choice

 How the investors rank investments opportunities
 Theory: Mean-variance theory of choice.
 Usingmean and variance to rank
 The mean – variance indifference curve
 The indifference curves
4

Three types of indifference

curves
 Commodity indifference

curve
 Consumption trade – off

indifference curve
 Risk – Return indifference

curve
 All types difference curve

derives from UTILITY

THEORY
 5 axioms of investor choice
5

 On
  what instincts do the investors make the investment decision?
 Axioms: Conditions/ Principles to consistently rank the opportunities
 Axiom I: Comparibility or Completeness
 For the entire set of uncertain alternatives, an individual can say either the that
either the outcome
 Axiom : Transitivity
 If an individual prefers to and to then is preferred to
 If
 Same with the indifference case
 If
 5 axioms of investor choice
6

  Axiom : Strong independence

 Define a gamble
 Win gets , Lose gets , Probability of winning is
 are mutually exclusive
So if then
 Axiom IV: Measurability
 If then there will be a probability (chance) that makes
 Meaning: Every continuous point can be measured.
 5 axioms of investor choice
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  Axiom Ranking
 Consider and
 I then
 If then
 Meaning: The gamble outcome is a Monotonic function of the

probability.
 Utility Function
8

 Building the Utility Functions on the basis of 5 axioms.

 Why building Utility functions?
 To compare and Rank investment opportunities
 Utility functions properties
 Order preserving (Monotonic function)
 Can be used to rank the opportunities.
 Representing the outcome of the investment opportunity.
 The model

 Does this function satisfy the above properties?

 Utility Function
9

  
 Order preserving: If then

 If Order preserving
 can be used to rank risky alternatives
 Using 4th and 5th Axiom
 Expected Utility of a gamble
10

 The expected Utility is the linear

combination of all Utilities of outcomes (2).

𝑧∈[𝑥 , 𝑦]
 If the Gamble entails multiple risky

alternatives
 Investment decision procedures
11

 Step I: Calculate the expected Utilities of all investment

alternatives.
 Need to estimate the alternative outcomes and the

respective probabilities
 Step II : Rank the Expected Utilities

 Step III: Choose the project with maximum Expected

Utilities
 Constructing the investor’s utility function
12

  Assign a loss of $1000 cause a loss of 10 utiles (Utility unit)

 An investor plays a gamble: G($1000, -$1000: What would make him/her
indifferent between the gamble and $0 with certainty?
 Mathematically,
 Assume makes the investors indifference 

(u)
 Investor’s utility function
13

  Repeating this process while changing the probability

$ Loss
$ Loss $ Winning
$ Winning Winning
Winning Winning
Winning
Utile
UtileLosing
Losing
Utile
Utile
Probability
Probability
 Investor’s Utility Function
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 Is this investor risk

neutral, risk
adverse or risk
lover?
 Risk aversion measure
15

 Traditional view: 3 Types of investors: Averse, Neutral, Lover.

 Assumption: All types prefer more to less
 Risk aversion measure
16

  
 Measuring risk aversion with a trial
 Consider a gamble
 Should the investor choose the expected return of the gamble
with certainty or to play the game?
 Risk aversion measure (contd.)
17

  A game:
 2 scenarios of the game
 Based on the actuarial value of the game:
 If the investors receive the actuarial value of $10 with the probability of 100%, their
utility will be:

 Based on the average utility of all outcomes

 If the investors get involved in the game

 Which scenario of the game is more preferred? Why?

 Risk aversion measure
18

 In
  general
 If Risk-adverse investor

 The investor perceives the Utility of the gamble

 If Risk neutral investor

 The investor is indifferent between two methods

 If Risk-loving investor

 Prefer to play the gamble more than receiving the certainty equivalent
outcome.
 Risk premium
19

  Risk-averse investors consider the result of the game as

 7.17 is certainty equivalent

 As for risk-averse investors, this certainty equivalent of the game is
smaller than its expected value ($10).
 Therefore, the investors are willing to pay the risk premium: 10-
7.17=2.83 to receive $10 for certain.
 If the insurance company sell the insurance package to ensure that the
investors will receive $10 for certain when taking part in the game with the
premium <=2.83, the investors will surely buy the package.
 Risk premium
20
 Risk premium
21

 How much will the investors be willing to pay to avoid the risk of
the game?
 An investor A, currently has $10. A is offered a game with a chance of
winning $40 (20% chance) and losing $5 (80% chance). After taking
part in the game, A either has 50 or 5. How much will A be willing to
pay to receive the actuarial value of the game for certain? Taking part in
the game is compulsory and there is no fee needed.
 Risk aversion measure: The alternative method
22


 Pratt(1964)
  and Arrow(1971) method
 Assuming B initially endowed W, facing an actuarially neutral gamble , . How much

should B pay for the insurance firm (risk premium) to be indifferent between
receiving the expected outcome with certainty and playing the game?
 Risk premium is a function of W  Premium =

 B is indifferent between the two alternatives:

: Expected Utility of the game

 : Risk premium
 :
 Taylor series
23

 A Taylorseries is a series expansion of a function around a point. A one-dimensional

Taylor series is an expansion of a real function f(x) about a point x=a is given by
Condition: has nth order derivative.

 Set
 Taylor series
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 Taylor series expansion

Terms of second order onward

Terms of third order onward

Terms of third order onward

since
 Risk premium: Pratt-Arrow
25

 Risk premium

Pratt Arrow Risk Premium

Absolute risk aversion

ARA and RRA are used to assess

Relative risk aversion
the Utility function.
 Exercises
26

 Calculate ARA and RRA for the following functions:

 Exercises (contd.)
27

 Second-order function

  2𝑏
𝐴𝑅𝐴=−
𝑎 −2 𝑏𝑊
 Exercises (contd.)
28


 Risk premium: Measure of risk aversion
29


 Pratt-Arrow
  method
 Risk premium = ARA or RRA
 Condition: Low-risk, actuarially neutral game (expected result=0)
 Markowitz method
 Risk premium =
 Pratt-Arrow conditions are not applied
 Markowitz vs. Pratt-Arrow
 Consider an individual with utility function U= the initial endowment . He/she is facing
two gambles:
 Gamble 1: win $10 and lose $10 with 50/50 chance.
 Gamble 2: lose $10,000 (probability 20%) or lose $1000 (probability 80%)
Calculate the risk premium using both methods for both gambles.
 Risk premium: Measure of risk aversion
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  Pratt-Arrow

 Gamble 1’s risk:

 Risk premium: Measure of risk aversion
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  Markowitz
 Risk premium: Measure of risk aversion
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 Gamble 2
 Markowitz risk premium: $489
 Pratt-Arrow risk premium: $324
 With low risk, 2 methods produce the same results.
 When Markowitz method produces different results compared with
Pratt-Arrow method
 When risk is high, prefer Markowitz method.
 Pratt-Arrow is meaningful in identifying an appropriate utility function
 Ranking assets
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   st order stochastic dominance:

1
 Asset A is preferred to Asset B if A yields
higher Utility than B in all economic
scenarios.
 is preferred to if for all
 are Cumulative Distribution Functions of
 The utility function is, presumably, order
preserving
 follows normal distribution with the distribution
function
 Ranking assets
34

  Risk adverse, neutral and lover prefer

to because for all order preserving
utility function

is the probability of the state

 The reverse result for non-increasing
utility function
 Ranking assets
35

  Ranking order 2
 Assuming concave utility function
 Order preserving
 Concave
 is ranked higher than for all if:
 Ranking assets
36

 2  nd order stochastic dominance:

 Concave utility function
 For Linear Utility function , Risk neutral
investor

 Thus, is preferred to
 Mean – Variance ranking method
37

 Ranking
  assets on the basis of

 If X and Y are both normally distributed, the linear combination

of X and Y also follow normal distribution.
 are the first and second moment of the series, respectively
 3rd and 4th moment are skewness and kurtosis
 is the expected return, the standard deviation of asset return
 Mean – Variance ranking method
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  Assuming one – period context:

 If then
 Expected return:
 Variance:

Because :
 Mean – Variance ranking method
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  If asset return follows normal distribution with mean and standard
deviation , the Utility function of this asset according to Tobin (1958)
is:

 Expected Utility

 Where: is the probability distribution of asset return

 Mean – Variance ranking method
40

  
 Risk averter indifference curve
 The indifference curve comprises
all investment opportunities having
the same expected Utility
 Indifference curve is convex
 For risk averter only
 Mean-variance method
41
 States of the economy
Very bad Bad Average Good Very good
Operating profit
42
Probability

FIRM A

Interest

Income before tax

Tax 50%

Net income

EPS (200 shares)

FIRM B

Interest

Income before tax

Tax 50%

Net income

EPS (100 shares)

43

($2.82, $7)

($1.41, $5)

 Risk aversion
44
45
46
 Drawback of mean-variance
47

 Mean-variance  A > B
 Second-order statistical dominance  A < B
 Mean-Variance assumes that asset return is normally distributed while
EPS is NOT normally distributed in the example.
 To conclude…
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 5 axioms of investor choice

 Constructing utility function on the basis of 5 axioms
 The investment decision is made through maximization of Expected
Utility
 Measuring risk aversion (risk premium)
 Markowitz
 Pratt-Arrow
 Assets ranking
 Stochastic dominance order 1
 Stochastic dominance order 2
 The indifference curve in the mean-variance space.
 Practice exercises
49

Exercise 1: Suppose you have a logarithmic utility function

U(W)=ln(W) and are exposed to the probability 30/70 of wining
$10,000 or losing $2,000.
(a) How much are you willing to pay for the insurance fee if your
current wealth level is 10,000$?
(b) How much are you willing to pay for the insurance fee if your
current wealth level is 1,000,000$?
 Practice exercises
50

Exercise 2: You have estimated the following probabilities for EPS of companies A and B:

Probability Company A Company B

0.1 0 -0.5
0.2 0.5 -0.25
0.4 1 1.5
0.2 2 3
0.1 3 4

(a) Calculate the mean and variance of EPS for each company.
(b) Explain how some investors might choose A and others might choose B if preferences are based on mean and
variance?
(c) Compare A and B, using the second-order stochastic dominance criterion.