Measures of Risk Aversion: Financial Economics

Measures of Risk Aversion
Financial Economics
Martn Sol
October 2010
Martn Sol (FE) Measures of Risk Aversion 08/10 1 / 41
Introduction
In this rst stage we will study the individual decisions of optimal
portfolio choice under uncertainty and its consequences in the
valuation of risky assets.
In short, the Financial Theory rests on the no-arbitrage principle. The
idea behind this principle is that it is not possible to make prots
without risk, without initial investment.
Risk Aversion (Jensens Inequality)
Consider the following situation: given an initial wealth w
o
, there is a
lottery where the possible results are
h
1
< 0 with probability p,
h
2
> 0 with probability (1-p).
A lottery is actuarially fair if the expected payo is 0,
h
1
p +h
2
(1-p) = 0.
Denition
An agent is risk averse if this agent is not willing to take an actuarially fair
lottery.
So, we have the following inequality
U(w
o
) _ U(w
o
+h
1
)p +U(w
o
+h
2
)(1-p).
Since, by denition, an actuarially fair lottery satises
w
o
= (w
o
+h
1
)p + (w
o
+h
2
)(1-p), we can rewrite the inequality as
U ((w
o
+h
1
)p + (w
0
+h
2
)(1-p)) _ U(w
0
+h
1
)p +U(w
0
+h
2
)(1-p)
This relation proves that the risk aversion implies that the agents
utility function to be concave, and a concave utility function implies
risk aversion.
If we dene the (ex-ante) wealth as a random variable w = w
o
+h,
where h is the random variable previously dened, the Jensens
Inequality can be expressed as
U(E( w)) _ E(U( w)).
Remember that concavity implies that the marginal utility of wealth is
decreasing. For a risk averse agent is worthless to take a fair lottery.
Risk Premium (Markowitz)
The risk premium , Rp, is dened as the amount of money that an
agent is willing to pay to avoid a lottery. So,
Rp = E( w) w
Rp
,
where w
Rp
is the certainty equivalent wealth dened as
U(w
Rp
) = E(U( w)).
Risk Premium (Arrow Pratt R. A.)
Instead of dening the measure of risk for a lottery we can use
another alternative measure.
A risk averse agent will be indierent between
1
..
U(w
Rp
) = U(w
o
-Rp) =
2
..
E(U( w)) = E(U(w
o
+h)).
= a fair lottery h such that h
1
p +h
2
(1-p) = 0
If we compute a rst-order Taylor expansion of the rst part around
w
o
, we get
U(w
o
-Rp) = U(w
o
)-U
/
(w
o
)(Rp) +O((w
o
-Rp)
2
),
where O(()
n
) is the rest of the Lagrangian for an order higher than n.
If we also expand U(w
o
+h) by Taylor around w
o
, we get
U(w
o
+h) = U(w
o
) +U
/
(w
o
)h +
U
//
(w
o
)
2
h
2
+O((w
o
-Rp)
3
).
Computing the expected value of U(w
o
+h),
E (U(w
o
+h)) = U(w
o
) +U
/
(w
o
)E(h)
..
=0
+
U
//
(w
o
)
2
E(h)
2
. .
.
=Var (h)
Then, making equal both expressions,
Rp = -
1
2
U
//
(w
o
)
2
h
U
/
(w
o
)
.
Using this last expression, we can dene the Coecient of Absolute
Risk Aversion (or Arrow Pratt Coecient) as
R
A
= -
U
//
(w
o
)
U
/
(w
o
)
.
This coecient measures the degree of aversion for each unit of risk.
Comparative Statics
Dierent utility functions imply a dierent behavior of the individual
in front of an increase in wealth.
Denition
A utility function U() exhibits decreasing absolute risk aversion if RA is a
decreasing function in wealth, i.e.,
dR
A
dz
< 0.
By analogy,
dR
A
dz
= 0 implies constant absolute risk aversion, and
dR
A
dz
> 0 increasing absolute risk aversion.
Comparative Statics
Note that,
dR
A
dz
=
d
_
-
U
//
(z)
U
/
(z)
_
dz
=
[(U
//
(z))
2
-U
/
(z)U
///
(z)]
(U
/
(z))
2
,
= [
(U
//
(z))
2
(U
/
(z))
2
-
U
/
(z)U
///
(z)
(U
/
(z))
2
],
=
_
R
A
_
2
-
U
///
(z)
(U
/
(z))
U
//
(z)
U
//
(z)
,
=
_
R
A
_
2
+R
A
U
///
(z)
U
//
(z)
,
Hence, U
///
(z) > 0 is a necessary condition for
dR
A
dz
< 0.
Risky and free-risk Assets (portfolio choice)
Consider a representative agent that has the possibility to invest its
wealth in a risk-free asset that pays an interest rate r (the next period
it would get a certain income), or alternately the agent can buy a
risky asset (take a lottery).
Suppose that in this economy there are J risky assets and one
risk-free asset.
The risk-free rate is r
f
and the return on the risky assets is r
p
dened
as r
p
=
j

j
r
j
, where
j
es the proportion of the j -th asset in the
portfolio, and r
j
the return on the asset j .
The agent has to choose how much of w
o
, (w
o
-
j
a
j
), it will invest for
sure in the risk-free asset and how much in the risky assets, (
j
a
j
),
where a
j
is the amount invested in each risky asset. At the same
time, the agent has to decide the proportions of each risky assets
(note that
j
=
a
j
j
a
j
).
So, the agent solves the following optimization problem
max
a
j
E(U( w))
where
w = (w
o
-
j
a
j
)(1 +r
f
) +
j
a
j
(1 +r
j
).
The First Order Condition is
E(U
/
( w)(r
j
-r
f
)) = 0, \j .
Since we suppose U
/
> 0, then (r
j
-r
f
) < 0 or (r
j
-r
f
) > 0 can never
occur with probability 1, i.e. it must be satisedP(r
j
-r
f
> 0) (0, 1).
Theorems for Investment Choice
We will show three theorems that describe under which conditions the
agents will invest all their wealth in risky assets, in risk-free assets, or
in both.
Theorem
If there is not investment in risky assets, then \j E(r
j
) < r
f
.
Proof
If a
j
= 0 == w = w
o
(1 +r
f
) then, it must be true that
E(U
/
(w
o
(1 +r
f
))(r
j
-r
f
))
a
j
=0
_ 0, \j
since, the agent is satised or its utility would increase to negative values
of a
j
.
Taking into account that U
/
(w
o
(1 +r
f
)) is positive and constant, we get
E((r
j
-r
f
)) _ 0, \j
so,
E(r
j
) _ r
f
, \j
If any asset has positive return, then there will be positive investment
in some risky asset. In other words, if there is an asset j
/
such that
E(r
j
/ ) > r
f
, then there is an asset j such that a
j
> 0.
Second theorem:
Theorem
If there is not investment in the risk-free asset, then \j
E(r
j
-r
f
) _ R
A
(w
o
(1 +r
f
))w
o
E(r
j
-r
f
)
2
.
Proof
The demonstration will be for j = 1. The FOC of an agent that invests all
his wealth in the risky asset satises
E(U
/
(w
o
(1 +r ))(r -r
f
))
a=w
0
_ 0.
If we expand U
/
(w
0
(1 +r )) by Taylor around (1 +r
f
), we get
E(U
/
(w
0
(1 +r ))(r -r
f
))U
/
(w
0
(1 +r
f
))E((r -r
f
))+
+U
//
(w
o
(1 +r
f
))E(r -r
f
)
2
w
o
_ 0
Reordering,
E(r -r
f
)_-
U
//
(w
o
(1 +r
f
))
U
/
(w
o
(1 +r
f
))
w
o
E(r -r
f
)
2
_R
R
()E[(r -r
f
)
2
]
The third theorem is a corollary of the two previous theorems.
Corollary
An agent invests in both types of assets (risky and non-risky) if
0 _ E(r
j
-r
f
) _
U
//
(w
o
(1 +r
f
))
U
/
(w
o
(1 +r
f
))
w
o
E(r
j
-r
f
)
2
.
Arrows Theorem
The characteristics of the coecient R
A
allow us to determine if the
agent considers the risky asset as a normal good (under the
assumption that the agent must choose between a unique risky asset
and the risk-free one).
In 1970, Arrow proved that the decreasing (increasing) absolute risk
aversion over all the domain of R
A
() implies that the risky asset is
a(n) normal (inferior) good.
Theorem (Arrow)
If
dR
A
dz
< 0 ==
da
dw
o
> 0 ,\w
o
(it is also true that
dR
A
dz
> 0 ==
da
dw
o
< 0
and that
dR
A
dz
= 0 ==
da
dw
o
= 0)
Arrows Theorem
Proof
Since the individual chooses a to maximize its utility function, the FOC is
E(U
/
(w
o
(1 +r
f
) +a(r -r
f
))(r -r
f
)) = 0,
and since it is an interior solution, we can totally dierentiate it. Then,
da
dw
0
=
-E(U
//
( w)(1 +r
f
)(r -r
f
))
E(U
//
( w)(r -r
f
)
2
)
Since U
//
< 0 and (r -r
f
)
2
> 0 == the denominator is always negative. To
analyze the sign of the numerator we have to consider it when r < r
f
on
the one hand, and when r > r
f
on the other hand.
Arrows Theorem
Proof
If r < r
f
, then w < w
o
(1 +r
f
) (remember that w = w
o
(1 +r
f
) +a(r -r
f
)).
Since we suppose that R
A
() is decreasing (through all its domain),
R
A
( w) > R
A
(w
o
(1 +r
f
)).
Multiplying both sides of the inequality by -U
/
( w)(r r
f
),
U
//
( w)(r -r
f
) > -R
A
(w
o
(1 +r
f
))U
/
( w)(r -r
f
).
Similarly, if r > r
f
then w > w
o
(1 + r
f
), so R
A
( w) < R
A
(w
o
(1 + r
f
)).
Multiplying both sides of the inequality by -U
/
( w)(r -r
f
), we get
U
//
( w)(r -r
f
) > -R
A
(w
o
(1 +r
f
))U
/
( w)(r -r
f
).
Arrows Theorem
Proof
Taking the expected value of both equations, conditioning on the sign of
the spreads of rates. For the rst equation we get
E(U
//
( w)(r -r
f
)[r > r
f
) > E(-R
A
(w
o
(1 +r
f
))U
/
( w)(r -r
f
)[r > r
f
), (A)
and for the second,
E(U
//
( w)(r -r
f
)[r < r
f
) > E(-R
A
(w
o
(1 +r
f
))U
/
( w)(r -r
f
)[r < r
f
). (B)
Using the law of iterated expectations (E(E(y[x)) = E(y)), we get
E(U
//
( w)(r -r
f
)) = E(U
//
( w)(r -r
f
)[r > r
f
)Pr (r > r
f
)
+E(U
//
( w)(r -r
f
)[r < r
f
)Pr (r < r
f
),
Arrows Theorem
Proof
and,
E(-R
A
(w
o
(1 +r
f
))U
/
( w)(r -r
f
))
= E(-R
A
(w
o
(1 +r
f
))U
/
( w)(r -r
f
)[r > r
f
)Pr (r > r
f
)
+E(-R
A
(w
o
(1 +r
f
))U
/
( w)(r -r
f
)[r < r
f
)Pr (r < r
f
).
So, if we multiply the inequality (A) by Pr (r > r
f
) and the inequality (B) by
Pr (r < r
f
) and then we add them up, we get the unconditional expectations
E(U
//
( w)(r -r
f
)) > -R
A
(w
o
(1 +r
f
))E(U
/
( w)(r -r
f
)),
since the FOC of the agents maximization problem satises that
E(U
/
( w)(r -r
f
)) = 0, then the sign of
da
dw
o
is positive since
E(U
//
( w)(r -r
f
) > 0.
Pratts Theorem
The following theorem allows us to compare the behavior of dierent
agents in the presence of risk.
Theorem
If there are two agents i and k with R
A
i
(z) _ R
A
k
(z), then the agent i is
said to be more risk averse because it demands a larger premium than the
other.
We will show that if the individual i is more risk averse than the
agent k (both with the same initial wealth) then, the risk premium
demanded by the agent i to invest all its wealth in a risky asset must
be larger than the one demanded by the agent k.
Pratts Theorem
Assuming that the agent k wants to invest all its wealth in the risky
asset, then the FOC is
E(U
/
k
(w
o
(1 +r ))(r -r
f
)) = 0.
The proof consists in showing that,
E(U
/
i
(w
o
(1 +r ))(r -r
f
)) _ 0,
since this implies that the agent i would be better o if it invents less
in the risky asset, which also implies that the agent i demands a
larger risk premium to invest all its wealth in the risky asset.
Pratts Theorem
To prove the Pratts theorem, rst, we have to prove the following
lemma, which allows us to establish a relationship between the utility
functions of the agents.
Lemma
There is an increasing and concave function G, (G
/
> 0, G
//
_ 0), such
that
U
i
= G(U
k
) == R
A
i
(z) _ R
A
k
.
Pratts Theorem
Proof
To show that G is an increasing function, we take the st derivative, U
/
i
,
U
/
i
= G
/
()(U
/
k
)
then G
/
> 0. To show concavity, we have to dierentiate U
/
i
and then
dividing both sides of the equation by -U
/
i
= -G
/
()(U
/
k
), we get
-
U
//
i
U
/
i
= -
G
//
()(U
/
k
)
G
/
()
-
U
//
k
U
/
k
,
Rewriting this last expression, we get the risk aversion coecient of the
agent i
R
A
i
(z) = -
G
//
()(U
/
k
)
G
/
()
+R
A
k
.
Since R
A
i
(z)>R
A
k
it must be satised that G
//
()60.
Pratts Theorem
Proof
Consider the FOC for the agent i when this individual decides to invest all
its wealth in the risky asset
E(U
/
i
(w
o
(1 +r )(r -r
f
))) = E(G
/
()U
/
k
(w
o
(1 +r )(r -r
f
))).
We have to show that this expression is negative. So we will analyze the
right side of the equation and will determine its sign. Using the law of
iterated expectations again,
E(G
/
()U
/
k
(w
o
(1 +r )(r -r
f
)))
= E(G
/
()U
/
k
(w
o
(1 +r )(r -r
f
))[r >r
f
)Pr (r >r
f
)
+E(G
/
()U
/
k
(w
o
(1 +r )(r -r
f
))[r < r
f
)Pr (r < r
f
).
Pratts Theorem
Proof
Consider now the case when r >r
f
, so w
o
(1 + r )>w
o
(1 + r
f
). Using G
concave, U monotone and U
/
i
= G
/
()(U
/
k
), we can see that
E(G
/
(U
k
(w
o
(1 +r ))U
/
k
(w
o
(1 +r ))(r -r
f
)[r >r
f
)
6G
/
(U
k
(w
o
(1 +r
f
))E(U
/
k
(w
o
(1 +r ))(r -r
f
)[r >r
f
)
Similarly, when r < r
f
, it is satised that w
o
(1 + r ) < w
o
(1 + r
f
) so,
following the same reasoning, we get the same inequality as before, but
conditional to r < r
f
, i .e.,
E(G
/
(U
k
(w
o
(1 +r ))U
/
k
(w
o
(1 +r ))(r -r
f
)[r < r
f
)
6G
/
(U
k
(w
o
(1 +r
f
))E(U
/
k
(w
o
(1 +r ))(r -r
f
)[r < r
f
).
Pratts Theorem
Proof
Multiplying the inequalities by Pr (r >r
f
) and Pr (r < r
f
) respectively, and
summing them up we get (by the law of iterated expectations)
E(G
/
(U
k
(w
o
(1 +r )))U
/
k
(w
o
(1 +r ))(r -r
f
))
6G
/
(U
k
(w
o
(1 +r
f
))E(U
/
k
(w
o
(1 +r ))(r -r
f
))).
But by hypothesis we know that E(U
/
k
(w
o
(1 +r ))(r -r
f
)) = 0, which is the
FOC of the maximization problem of the agent k, so the right side of the
inequality is equal to 0. Then,
E(U
/
i
(w
o
(1 +r ))(r -r
f
))60.
Two-fund Monetary Separation
Stiglitz & Case (1970) showed that a necessary condition to the
existence of Two-fund Monetary Separation is that the marginal
utilities must be as
U
/
(z) = (A +Bz)
C
or,
U
/
(z) = AexpBz.
Next we show an (heuristic) proof. The wealth is dened as
w = w
o
(1 +r
f
+ (1-)
j
b
j
r
j
),
where is the proportion invested in the risk-free asset and b
j
is the
proportion invested in the j -th risky asset.
By showing that b
j
stays constant when w
o
changes we demonstrate
what we said before
To nd the optimal values of and b
j
, we must solve
max
,b
j
E(U( w))
sa :
b
j
= 1.
The Lagrangian is
L(, b
j
, ) = E
_
U
_
w
o
(1 +r
f
+ (1-)
j
b
j
r
j
)
_
+
_
1-
j
b
j
__
The FOCs are
: E(U
/
( w)w
o
(r
f
-
b
j
r
j
)) = 0,
b
j
: E(U
/
( w)w
o
(1-)r
j
) = .
The rst condition implies
E(U
/
( w)r
f
) = E(U
/
( w)
b
j
r
j
),
And the second condition,
E(U
/
( w)r
j
) =
/
where
/
= / (w
o
(1 )) .
Now, using E(U
/
( w)r
j
) =
/
(constant), we can rewrite the
derivative with respect to a as
E(U
/
( w)r
f
) =
b
j
E(U
/
( w)r
j
)
. .
constant
= E(U
/
( w)r
j
)
since the sum of the weights is 1.
Hence,
E(U
/
( w)(r
j
-r
f
)) = 0.
If we assume that the marginal utility has one of the functional forms
seen before (for example U
/
(z) = (A +Bz)
C
with B > 0, C < 0 y
Z > max(0,-
A
B
)), it can be proved that a change in the initial wealth
leaves the proportions invested in the risky assets constant (b
j
= b
/
j
).
From the FOCs and substituting U
/
(z) = (A +Bz)
C
, where
z = w
o
(1 +r
f
+ (1-)
j
b
j
r
j
), we get
E((A +B(w
o
(1 +r
f
+ (1-)
j
b
j
r
j
)))
C
(r
j
-r
f
)) = 0,
And similarly, for another level of initial wealth, we would be able to
derive
E((A +B(w
/
o
(1 +
/
r
f
+ (1-
/
)
j
b
/
j
r
j
)))
C
(r
j
-r
f
)) = 0.
It can be proved that this two conditions imply the following
relationship between the parameters
w
/
o
(1-
/
)b
/
j
=
A +B(w
/
o
(1 +r
f
))
A +B(w
o
(1 +r
f
))
w
o
(1-)b
j
, \j . (C)
The proof that the proportions invested in the risky assets dont
change if we modify the initial wealth is shown by applying the sum
operator at both sides of the last expression and since
j
b
/
j
=
j
b
j
= 1, we get
w
/
o
(1-
/
) =
A +B(w
/
o
(1 +r
f
))
A +B(w
o
(1 +r
f
))
w
o
(1-). (D)
So, only if b
/
j
= b
j
, (C) y (D),they can be satised simultaneously.
This implies that, although the proportions invested in the risky assets
dont change when the initial wealth is modied, the allocation
between risky and non-risky assets changes (see that ,=
/
in (D)).
Appendix (OPTIONAL)
Portfolio Choice: an approximation
Lets think that the agent solves the following problem
_
max
E
_
U
_
W
__
sujeto a

W = W
0
[1 + (1-
/
I ) r
f
+
/
r ]
where is the vector of the n assets weights, r
n+1
is the vector of
(random) returns, r
f
is a scalar which denotes the risk-free assets
return in this economy, W
0
is a scalar which denotes the agents
initial wealth and I
n+1
is a vector of ones.
Appendix
The FOC is
E(U
/
( w)(r
j
-r
f
)) = 0, \j = 1, . . . , n.
In matrix form,
E(U
/
( w)(r -r
f
I )) = 0
n+1
(1)
We take a rst order Taylor expansion of U
/
_
W
_
around W
0
(1 +r
f
)
so we can get an approximate solution of the optimal weights,
U
/
_
W
_
U
/
(W
0
(1 +r
f
)) +U
//
(W
0
(1 +r
f
))
_
W-W
0
(1 +r
f
)
_
.
Appendix
Note that
W-W
0
(1 +r
f
) = W
0
/
(r -r
f
I ) ,
Then, we can rewrite the approximation as
U
/
_
W
_
U
/
(W
0
(1 +r
f
)) +U
//
(W
0
(1 +r
f
)) W
0
/
(r -r
f
I )
Postmultiplying by (r r
f
I ) and taking the expected value at both
sides of the equation,
E
_
U
/
_
W
_
(r -r
f
I )
_
U
/
(W
0
(1 +r
f
)) E (r -r
f
I ) (2)
+U
//
(W
0
(1 +r
f
)) W
0
E
_
/
(r -r
f
I ) (r -r
f
I )

Appendix
Note that
/
(r r
f
I ) is a scalar, so
/
(r -r
f
I ) (r -r
f
I ) = (r -r
f
I )
/
(r -r
f
I ) , (3)
= (r -r
f
I ) (r -r
f
I )
/
, (4)
Substituting(4) into (2) and this into (1), we get
U
/
(W
0
(1 +r
f
)) E (r -r
f
I ) +U
//
(W
0
(1 +r
f
)) W
0
E [R] = 0,
where R = (r r
f
I ) (r r
f
I )
/
.
Isolating ,
= -
U
/
(W
0
(1 +r
f
))
U
//
(W
0
(1 +r
f
)) W
0
[E (R)]
1
E (r -r
f
I ) . (5)
This is an approximation for the optimal weights of the portfolio.
Appendix
Example
Suppose that
U(X) =
X
1
1
then,
-
U
//
(W
0
(1 +r
f
)) W
0
U
/
(W
0
(1 +r
f
))
=

1 +r
f
so the optimal weights are
=
1 +r
f
[E (R)]
-1
E (r -r
f
I )

Measures of Risk Aversion: Financial Economics

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Measures of Risk Aversion

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