1. This document discusses risk aversion and how utility functions are used to model it. A decision maker is risk averse if they are unwilling to accept a fair gamble that has equal chances of higher or lower monetary outcomes. Their concave utility function results in the utility of the expected monetary value being greater than the expected utility.
2. An example shows a decision maker who is willing to pay $5,661 for insurance on a $500,000 house, even though the expected loss is only $5,000, demonstrating risk aversion. An insurance company would still find it worthwhile to insure the house due to the small impact on their much larger assets.
3. Certainty equivalents can
1. This document discusses risk aversion and how utility functions are used to model it. A decision maker is risk averse if they are unwilling to accept a fair gamble that has equal chances of higher or lower monetary outcomes. Their concave utility function results in the utility of the expected monetary value being greater than the expected utility.
2. An example shows a decision maker who is willing to pay $5,661 for insurance on a $500,000 house, even though the expected loss is only $5,000, demonstrating risk aversion. An insurance company would still find it worthwhile to insure the house due to the small impact on their much larger assets.
3. Certainty equivalents can
1. This document discusses risk aversion and how utility functions are used to model it. A decision maker is risk averse if they are unwilling to accept a fair gamble that has equal chances of higher or lower monetary outcomes. Their concave utility function results in the utility of the expected monetary value being greater than the expected utility.
2. An example shows a decision maker who is willing to pay $5,661 for insurance on a $500,000 house, even though the expected loss is only $5,000, demonstrating risk aversion. An insurance company would still find it worthwhile to insure the house due to the small impact on their much larger assets.
3. Certainty equivalents can
1. This document discusses risk aversion and how utility functions are used to model it. A decision maker is risk averse if they are unwilling to accept a fair gamble that has equal chances of higher or lower monetary outcomes. Their concave utility function results in the utility of the expected monetary value being greater than the expected utility.
2. An example shows a decision maker who is willing to pay $5,661 for insurance on a $500,000 house, even though the expected loss is only $5,000, demonstrating risk aversion. An insurance company would still find it worthwhile to insure the house due to the small impact on their much larger assets.
3. Certainty equivalents can
DA 5. Risk Aversion George E. Apostolakis Massachusetts Institute of Technology
Spring 2007
DA 5. Risk Aversion
Calibration of utility functions
We can apply a positive linear transformation to a utility function and get an equivalent utility function. (x) = a U(x) + b a>0
A calibrated utility function is such that (C*) = 0 and (C*) = 1
2
DA 5. Risk Aversion
Example Suppose that it has been determined that U(x) = ln(x+5) Let C = 2
for and
-4.5 x 4.5 (in $ million)
C = 2
Let (x) = aln(x+5) + b.
Then,
1 = aln(7) + b and 0 = aln(3) + b to obtain a = 1.18 and b = -1.29
DA 5. Risk Aversion 3
DA 5. Risk Aversion
The Buying Price for a Lottery
It is the purchase price at which the DM is indifferent between the alternatives of buying the lottery and not buying it. Let (x) the DMs utility function with (0) the utility of his present assets, i.e., before he buys the lottery. p1
Example (contd) ln[(6-BP) (5-BP)] = 3.22 (BP)2 11(BP) + 30 = exp(3.22) = 25.04 (BP)2 11(BP) + 4.96 = 0 BP = 0.47 (the other root is 10.53 and is rejected)
EMV = 1x0.5 + 0x0.5 = 0.5 > 0.47 risk aversion
DA 5. Risk Aversion
The Selling Price of a Lottery
SP = CE (certainty equivalent)
We now interpret x = 0 to represent the DMs total assets except of the lottery. Utility of present wealth (situation) is (L).
Risk Aversion The DM is always willing to sell any lottery for less than its expected monetary value. L(x1, x2; p1, p2) EMV = p1 x1 + p2 x2
U(p1 x1 + p2 x2) = U(EMV) > p1 U(x1)+ p2 U(x2) A DM with a concave utility for money will refuse a monetarily fair bet and is said to be risk averse. DA 5. Risk Aversion 10
Example L(1, 0; 0.5, 0.5) EMV = $0.5 M (0.5) = 0.6091 SP = $0.4771
0.5 (1) + 0.5 (0) = 0.7167
Risk Premium EMV CE = 0.5 0.4771 RP = $0.0229 M
DA 5. Risk Aversion 11
Risk Aversion and Insurance
You own a house worth $500,000. A fire (p = 10-2 per year) may destroy it completely. Your utility function is (x) = 1.18ln(x+5) 1.29; C* = $2M, C* = -$2M
(-0.5) = 1.18ln(4.5) 1.29 = 0.4848 (0.0) = 0.6091 (NI) = 0.4848 x 10-2 + (1- 10-2) x 0.6091 = 0.6078 (-x) = 0.6078 x = $5,661 DA 5. Risk Aversion 14
Your Perspective You are willing to pay up to $5,661 to insure your house. The expected loss is 10-2 x $500,000 = $5,000 < $5,661
You are willing to pay more than the expected loss because you are risk averse. DA 5. Risk Aversion 15
The Companys Perspective
Why would the insurance company agree to insure you? The company may win $5,661 with probability 0.99 or lose $494,339 with probability 10-2.
DA 5. Risk Aversion
16
The Companys Decision Tree
p Accept I 5,661
- 494,339
1-p Do not Accept I
0.00
1-p 0.00 DA 5. Risk Aversion 17
The Companys Perspective (2)
The company has $1 billion dollars in assets. Its wealth is either $999,505,661 with probability 10-2, or $1,000,005,661 with probability 0.99. For such small changes, the companys utility of money is linear, i.e., the company makes decisions using the EMV. EMV = 5,661 x 0.99 - 494,339 x 10-2 = $661 DA 5. Risk Aversion 18
The Companys Perspective (3)
The alternative is for the company to refuse the premium, in which case the EMV is zero. The company should agree to insure the house. Note: The companys overhead expenses have not been factored in. DA 5. Risk Aversion 19
Assessment Using Certainty Equivalents
1. 2. Set U(C*) = 0 and U(C*) = 1
Consider the reference lottery L1(C*, C*; 0.5, 0.5)
Its certainty equivalent is derived by solving U(CE1) = 0.5 U(C*) + 0.5 U(C*) = 0.5 DA 5. Risk Aversion 20
Assessment Using Certainty Equivalents (2)
Thus, we have found a third point of the utility function, that with utility 0.5. 3. Repeat the process with a new reference lottery L2(C*, CE1; 0.5, 0.5) Solve U(CE2) = 0.5 U(C*) + 0.5 U(CE1) = 0.75 to get a fourth point of the utility function, CE2. DA 5. Risk Aversion 21
