Certainty Equivalent and risk

premium

How to deal with uncertainty

 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
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 The Utility Function
U(W)
3.40
3.00

2.30 Let U(W) = ln(W)

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 3
 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

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 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

Consider the following example:

80% change of winning $5

20% chance of winning $30

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

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

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

= (0.8)*(1.61) + (0.2)*(3.40)
= 1.97
Therefore, U[(E(W)] > E[U(W)] -- uncertainty reduces utility 5
 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
Log (7.17)=1.97
Certainty equivalent: 7.17
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 6
 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
• CE = 7.17 as log (7.17)=1.97
• 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

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 The Risk Premium
• Risk Premium:
– the amount that the individual is willing to give up in order to avoid the gamble

• Recall 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

Ln(CE)=1.97, i.e U(CE)=E[U(W)], CE=7.17, RP=10-7.17=$2.83

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 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 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