Risk and lotteries Expected utility The price of risk Utility functions

Lecture 1:
Risk aversion and choice under uncertainty

MFIN6214 Financial Theory and Policy – T3 2020

Risk and lotteries Expected utility The price of risk Utility functions

Risk and uncertainty: At the core of finance

I Risk and uncertainty are everywhere: weather, politics, health,

investment, ...
I In financial markets, investors trade assets with random future
payoffs: stocks, bonds, derivatives, currencies, ...
I What should be their price?
I In a frictionless market, their price depend on the economic
fundamentals, the time preferences, and the risk preferences
of economic agents.
I Once we understand these time and risk preferences, we can
understand asset pricing.
I This is the goal of this course.
Risk and lotteries Expected utility The price of risk Utility functions

A simple example
Why intuitions only get you so far. . .

Example 1:
I Consider a lottery whose payoffs are $1,000 with probability
0.4, and 0 with probability 0.6.
I If you were risk neutral, the price of this lottery would be its
expected payoff. Which is?
I But what would you be willing to pay to participate in this
lottery? $300? $200?
I Intuitively, it should depend on your preferences:
I Are you adventurous or cautious?
I What is your level of risk aversion?
I It may also depend on your wealth.
I Bottom line: even this simple example is too complicated to
be solved “intuitively”. We need theoretical guidance.
Risk and lotteries Expected utility The price of risk Utility functions

Another simple example

Example 2:
I The gamble is the following: someone offers you to flip a fair
coin. If it’s tails you receive $1 and that’s it. If it’s heads the
coin is flipped again. If it’s tails you receive $2 and that’s it.
If it’s heads the coin is flipped again. At every round, the
amount paid if tails obtains doubles.
I How much would you be willing to pay to play this gamble?
Risk and lotteries Expected utility The price of risk Utility functions

Another simple example

A shocking result

Example 2:
I Suppose that you are risk neutral. Then the price of this
gamble is given by its expected payoff.
1
I With probability 2 you get $1.
1
I With probability 4 you get $2.
1
I With probability 8 you get $4.
I ...
I The expected payoff is
∞   ∞
X 1 i X 1
× 2i−1 = =∞
2 2
i=1 i=1
Risk and lotteries Expected utility The price of risk Utility functions

Another simple example

Example 2:
I This gamble has an infinite value! But no one would pay an
infinite amount of money to play this gamble.
I With a 93% probability, it pays off $8 or less. The probability
to get more than $64 is only 1%. . .
I The expectation of a lottery is therefore not an adequate
measure of its value.
I It seems that economic agents either severely discount these
very high payoffs (this is the idea behind the utility function),
or underweight these extreme probabilities (this is the idea
behind risk neutral probabilities).
I Solution to this puzzle: accounting for risk aversion.
Risk and lotteries Expected utility The price of risk Utility functions

Lotteries

I Let’s assume that the outcome is unidimensional: money

I The set of possible outcomes is X ≡ {xs }s=1,...,S . s denotes
the state of the world. We denote the random outcome by x̃.
I A lottery L is described by a vector of probabilities
(p1 , . . . , pS ) over X .
Example 3:
I Suppose that S = 3, and the possible outcomes are x1 = 1,
x2 = 10, x3 = 16.
I Lottery La is defined by p1 = 0.1, p2 = 0.8 (p3 = 0.1).
I Lottery Lb is defined by p1 = 0.2, p2 = 0.3 (p3 = 0.5).
I Which lottery is preferred? We first need to introduce
preferences and expected utility!
Risk and lotteries Expected utility The price of risk Utility functions

Preferences

I In consumer theory, preferences are defined over baskets of

goods.
I In financial economics, preferences are defined over lotteries.
I Axioms on preferences:
I Completeness: for any two lotteries La and Lb , either La  Lb
or Lb  La .
I Transitivity: If La  Lb and Lb  Lc then La  Lc .
I Continuity: If La  Lb  Lc , there exists a scalar α ∈ [0, 1]
such that Lb ∼ αLa + (1 − α)Lc .
I A preference relation which is both complete and transitive is
rational.
Risk and lotteries Expected utility The price of risk Utility functions

Preferences

I Theorem: Given a preference relation which satisfies these

axioms, there exists a preference functional U which maps any
lottery L ∈ L into R such that La  Lb ⇔ U(La ) ≥ U(Lb )
I NB: U is not unique. Consider any increasing function g .
Then V () ≡ g (U()) represents the same preferences as U, in
the sense that it will yield the same ordering of lotteries.
I Put differently, an individual with preference functional U
would always choose the same lotteries as an individual with
preference functional V : they would behave in the same way.
Risk and lotteries Expected utility The price of risk Utility functions

Choice criterion: expected utility

I Theorem (von Neumann and Morgenstern): If the preference
relation satisfies several axioms (completeness, transitivity,
continuity, independence) then it can be represented by a
preference functional which is linear in probabilities.
I This means that, for each outcome xs , ∃us s.t.
S
X S
X
La  Lb ⇔ psa us ≥ psb us
s=1 s=1

I Or, with outcomes continuously distributed in [0, ∞), there

exists a function u such that:
Z ∞ Z ∞
La  Lb ⇔ u(xs )dΦa (xs ) ≥ u(xs )dΦb (xs )
0 0

where Φa is the cumulative distribution function (c.d.f.) of x̃

with the lottery a.
Risk and lotteries Expected utility The price of risk Utility functions

Choice criterion: expected utility cont’

I We can also write that Ea [u(x̃)] ≥ Eb [u(x̃)].

I The utility function u(x) tells us the level of satisfaction or
utility u(x) attained by the agent with the outcome x.
I A lottery should then be valued according to the expected
utility that it provides.
I NB: The utility function u is not unique. Any increasing linear
transformation of u will give the same ranking of lotteries.
Risk and lotteries Expected utility The price of risk Utility functions

Risk aversion
I Definition: An agent is risk averse if he dislikes all
zero-mean risks at all wealth levels.
I This implies that, for a risk averse agent,
E [u(w + ˜)] < E [u(w )] = u(w ) = u(E [w ]) = u(E [w + ˜]),
where E [˜
] = 0.
I Proposition: An agent is risk averse if and only if his utility
function u is concave.
I Jensen inequality:

E [u(x̃)] ≤ u(E [x̃]) if and only if u is concave

I A risk-averse agent always prefers receiving the expected

outcome of a lottery with certainty, rather than the lottery
itself.
Risk and lotteries Expected utility The price of risk Utility functions

Risk aversion
Illustration
1.2. Definition and Characterization of Risk Aversion 7

e
f
utility

c d

4000 8000 12 000

wealth
Figure 1.1. Measuring the expecting utility of final wealth (4000, 21 ; 12000, 21 ).
Risk and lotteries Expected utility The price of risk Utility functions

Risk aversion

I What are the implications of concavity for marginal utility?

The potential loss of 1$ reduces utility more than the increase
in utility generated by the potential gain of 1$. So agents
dislike uncertainty.
I Risk aversion explains the behavior of economic agents:
I Purchase of insurance at a premium.
I Purchase of risky assets at a discount.
I What is the form of the utility function of a risk neutral
agent? How much would he pay for insuring risk?
I And if the agent is risk lover?
Risk and lotteries Expected utility The price of risk Utility functions

Applying the expected utility criterion

Recall example 3:
I The possible outcomes are x1 = 1, x2 = 10, x3 = 16.
I Lottery La is defined by p1 = 0.1, p2 = 0.8 (p3 = 0.1).
I Lottery Lb is defined by p1 = 0.2, p2 = 0.3 (p3 = 0.5).
I Consider the power utility function such that u 0 (x) = x −γ .1
γ = 0 γ = 0.5 γ = 1 γ = 2
Ea [u(x̃)] 9.7 6.1 2.12 −0.2
Eb [u(x̃)] 11.2 6.3 2.08 −0.3

1 x 1−γ
It can be represented by u(x) = ln(x) for γ = 1, and u(x) = 1−γ
otherwise.
Risk and lotteries Expected utility The price of risk Utility functions

Risk premium and certainty equivalence

I Given the utility function, can we quantify the tradeoff
between risk and return?
I In other words, can we find the maximum amount of money
that the agent would be willing to pay to eliminate a pure
risk? This amount is called the risk premium, Π. In the case
of a risk ˜ which is additive in wealth, Π solves:
E [u(w + ˜)] = u(w − Π) where E [˜
] = 0
I This amount Π is positive if the agent is risk averse:
E [u(w + ˜)] < u(w ) if u is concave
I Another similar concept is the certainty equivalent. Given a
lottery x̃ (whose expected payoff is not necessarily zero), the
certainty equivalent CE is the value of the lottery such that:
E [u(w + x̃)] = u(w + CE )
Risk and lotteries Expected utility The price of risk Utility functions

The Arrow-Pratt approximation (1)

A closed form expression for the tradeoff between risk and return

I Consider a pure risk ˜ additive in wealth: end-of-period wealth = w + ˜.

I Then the absolute risk premium (expressed as the amount of wealth)
associated with this risk is
1
Π≈ A(w )σ 2
2
00
] = σ 2 and A(w ) ≡ − uu0 (w
where var [˜ (w )
)
> 0.
I This approximation is only approximately valid for small risks.
I The risk premium is increasing in the variance of the payoff, σ 2 .
I The risk premium is increasing in the concavity of the utility function
(which is a measure of risk aversion) at w : the coefficient of absolute risk
aversion A(w ) is a measure of the tradeoff between risk and return at w .
I The coefficient of absolute risk aversion A(w ) measures the agent’s
preferences regarding additive risks.
Risk and lotteries Expected utility The price of risk Utility functions

The Arrow-Pratt approximation (1)

A closed form expression for the tradeoff between risk and return
1.3. Risk Premium and Certainty Equivalent 11
utility

4000 8000 − Π 8000 12 000

wealth
Figure 1.2. Measuring the risk premium P of risk (−4000, 21 ; 4000, 21 )
when initial wealth is w = 8000.
Risk and lotteries Expected utility The price of risk Utility functions

The Arrow-Pratt approximation (2)

A closed form expression for the tradeoff between risk and return

I The index of absolute risk aversion is not unit free, as it varies in euro,
dollar, ...
I Consider now a pure risk ˜ multiplicative in wealth, so that the
end-of-period wealth is w (1 + ˜).
I Then the relative risk premium (expressed as a share of wealth)
associated with this risk is
1
Π̂ ≈ R(w )σ 2
2
00
] = σ 2 and R(w ) ≡ −w uu0 (w
where var [˜ (w )
)
= wA(w ) > 0.
I The index of relative risk aversion R(w ) is the rate at which marginal
utility decreases when wealth is increased by 1%.
I The coefficient of relative risk aversion measures the agent’s preferences
regarding pure and small multiplicative risks.
Risk and lotteries Expected utility The price of risk Utility functions

The Arrow-Pratt approximation (3)

A closed form expression for the tradeoff between risk and return

Example 4:
I Suppose your wealth is subject to a risk of a gain or loss of
20% with equal probability.
I What is the share of your wealth that you would be ready to
pay to get rid of this zero-mean risk?
I The variance of your wealth is
σ 2 = 0.5 × 0.22 + 0.5 × −0.22 = 4%.
I Reasonable values for relative risk aversion range between 1
and 10. So let’s say R(w ) = 5. Then,

1 1
Π̂ ≈ R(w )σ 2 = × 5 × 4% = 10%
2 2
Risk and lotteries Expected utility The price of risk Utility functions

Wealth and risk aversion

I Intuitively, a millionaire will not be as averse to winning or

losing $100 as a struggling student.
I “History tells us that risk appetite increases as per capita
incomes go up.” Financial Times (Dec 2011)
I Definition: Preferences are characterized by decreasing
absolute risk aversion (DARA) if the risk premium associated
to any pure additive risk is decreasing in wealth.
I Preferences are DARA if and only if A(w ) is decreasing in w .
I A necessary condition is u 000 (w ) > 0 (this is called prudence),
√
i.e., a convex marginal utility. Example: u(w ) = w .
I In this case, an increase in wealth reduces the risk premium.
Risk and lotteries Expected utility The price of risk Utility functions

Quadratic utility
Vintage: popular in the 1950s

I Simple form:
u(w ) = aw − bw 2
I Advantage: preferences are fully described by the mean and
the variance of the payoff.
I Drawbacks:
I Only defined on the interval of wealth where marginal utility is
positive. Problem arises when w > a.
I Increasing absolute risk aversion, which is undesirable feature.
I Also, no prudence, as u 000 (w ) = 0.
Risk and lotteries Expected utility The price of risk Utility functions

Constant absolute risk aversion

CARA

I The coefficient of absolute risk aversion A(w ) is a constant

function of wealth with the following utility function (also
known as negative exponential):

u(w ) = − exp{−ρw }

I As you can check, A(w ) = ρ.

I With these preferences, an economic agent is as averse to an
additive risk if he owns $10 or $1,000,000: constant absolute
risk aversion.
I Features increasing relative risk aversion.
I Unrealistic. . . but these utility functions are tractable
(especially with a normally distributed risk) and are used in
stylized models.
Risk and lotteries Expected utility The price of risk Utility functions

Constant relative risk aversion

CRRA, or “power utility”
I The coefficient of relative risk aversion R(w ) is a constant
function of wealth with the following utility function:
( 1−γ
w
1−γ if γ 6= 1
u(w ) =
ln(w ) if γ = 1

I As you can check, R(w ) = γ. Constant RRA.

I With these preferences, an economic agent is as averse to a
multiplicative risk whether he owns $10 or $1,000,000.
I It is also known as the isoelastic utility function: the elasticity
of substitution between consumption at any two points in
time is equal to γ1 .
I Features decreasing absolute risk aversion.
I Widely used in macroeconomics and finance, with γ ∈ [1, 10].
Risk and lotteries Expected utility The price of risk Utility functions

What is your coefficient of relative risk aversion?

I Which proportion of your wealth would you be willing to pay

to escape the risk of your wealth either increases or decreases
by k = 10% with equal probabilities?
I Suppose you own $50,000. If you participate in the lottery,
your wealth will be $45,000 with probability 0.5, or $55,000
with probability 0.5. What percentage of $50,000 would you
be willing to pay to escape this risk?
I Answer the same question with 30% instead of 10%.
I Of course, your answer will also depend on personal
circumstances, notably to what extent you are exposed to
other sources of risk. More on this later on.
Risk and lotteries Expected utility The price of risk Utility functions

What is your coefficient of relative risk aversion?

coef RRA k = 10% k = 30%

γ = 0.5 0.3% 2.3%
γ=1 0.5% 4.6%
γ=4 2.0% 16.0%
γ = 10 4.4% 24.4%
γ = 40 8.4% 28.7%
I A RRA less than one may be considered a low risk aversion,
whereas a RRA higher than four may be considered a high risk
aversion.
Risk and lotteries Expected utility The price of risk Utility functions

Caveats of the expected utility criterion

I The Allais paradox: violation of the independence axiom at

the heart of the expected utility criterion. Agents make
inconsistent choices.
I Another paradox.
I Your wealth is $6,000. You have the option to pay $2,000 to
get $8,000 with probability 0.5 or $0 with probability 0.5.
I Your wealth is $12,000. You can either choose to lose $8,000
with probability 0.5 or $0 with probability 0.5, or pay $6,000 to
escape this lottery.
I What do you prefer?
I Framing: preferences over lotteries depend on whether they
are presented as a gamble or as insurance.
Risk and lotteries Expected utility The price of risk Utility functions

Takeaway I

I We only need to assume that economic agents have

preferences over lotteries (i.e. distributions of future random
payoffs) which satisfy certain axioms.
I Then we know that there exists a preference functional U
which ranks these lotteries in the same way as their preference
relation.
I We also know that there exists a utility function u such that a
lottery is preferred to another one if and only if it gives a
higher expected utility.
Risk and lotteries Expected utility The price of risk Utility functions

Takeaway II

I A risk averse agent has a concave utility function.

I We can derive the price of a small risk, whether it is additive
or multiplicative in wealth.
I We can use different functional forms for the utility function,
with different implications for ARA and RRA as a function of
wealth.
I In practice, most models specify a utility function u which is
taken as a given. The expected utility criterion is then used to
determine the choices that agents will make under uncertainty,
which in turn determine the prices of financial assets.