Financial decision-making under uncertainty

Rafael Serrano and Carlos Castro

Financial Economics
February 2020

1
 Decisions without uncertainty
Decisions over goods and services depends on preferences X A and Xb .
Microeconomics 101 consumer problem:
máx U ( X A , XB ); PA X A + PB XB ≤ W

Prices are known.

One period.
Solution is demand equation, Xi = f ( PA , W; PB ).

Now suppose we have one good and two periods: time when decision is made (0)
and a period after (1). Define value at state s as Vis = Pi Xi
máx U (V0, V11, . . . , V1S )
Goods collapse into wealth, quantities (latter) are allocations and the realizations
of prices are known but you do not know for sure which will come about. Utility is
derived from a basket of potential realizations

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 Risk preferences
Risk is an ever-prevalent challenge to both individuals and society. When you dress
yourself every morning, probably you ask the question: what will the weather be like
today?
After recalling the latest weather forecast, you may wonder whether it is accurate
or not. The weather forecast itself relies heavily on the rules of probability theory,
as does the fact that today’s weather might not behave as the forecast predicts.
How you react to the uncertain weather ahead says something about your so-called
“risk preferences.”
If the forecast calls for a 10 % chance of rain, do you carry your umbrella when you
walk to a restaurant for lunch?
How about with a 50 % chance of rain? Obviously the answer will not be the same
for each individual.

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 Lotteries and preferences
Decision theories under risk and uncertainty use so-called lotteries and preference
relations.
A lottery is a given set of states together with their respective outcomes and
probabilities. Simple mechanism to introduce uncertainty
A preference relation is a set of rules that states how we make pairwise decisions
between lotteries. If we prefer lottery A over lottery B, we will use the notation
AB
If we are indifferent between A and B we write
A∼B

Expectations over payoffs.

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 State-independent
In financial theory, it is often assumed that preferences over financial assets are
state-independent.
In the state-independent case, a lottery can be described only by the outcomes and
their respective probabilities.
If the outcomes are numbers (like the payoff or gain of a gamble or the value of a
portfolio) we may use a random variable to represent these outcomes, and associate
the lottery to the probability distribution of the random variable.

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 Example: Benoulli Game
Two states { H, T }. Define payoff over states. In financial parlance equivalent game
for the value of an asset over a time period {U p, Down}.
Fair coin has the following distribution:

P( L = H ) = P( L = T ) = 1/2.
Tosses ( L) are independent
Define Arbitrary payoff over realizations, for example H/U p = 10, T/Down =
−10.
Expected payoff: 12 (10) + 21 (−10) = 0

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 Should financial decisions be made on expected return?
An important breakthrough in the analysis of decisions under risk was achieved in
1738 with the publication (in Latin) of the paper by the Swiss mathematician Daniel
Bernoulli titled “Specimen theoriae novae de mensura sortis,” or “Exposition of a
new theory on the measurement of risk.”
Early modern financial theory focuses on decision over financial assets based only
on expected outcomes (1 dimensional).
Bernoulli proposed the following game for a single player in a hypothetical casino in
St. Petersburg:
A fair coin is tossed at each stage. The initial stake starts at $2 and is doubled
every time heads appears. The first time tails appears, the game ends and the player
wins whatever is in the pot.

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 Thus the player wins $2 if tails appears on the first toss, $4 if heads appears on the
first toss and tails on the second, $8 if heads appears on the first two tosses and
tails on the third, and so on.
In summary, the player wins 2k dollars, where k equals number of tosses.
The question is: how much would you be willing to pay as an entrance fee to play
this lottery?
If expected value is followed as decision criteria, we should be willing to pay an
entrance fee up to this expected gain.

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 The probability pk that the coin will show “tail” after exactly k times is
pk = P(“head” on 1st toss) · P(“head” on 2nd toss) · · · P(“tail” on k-th toss)
 1 k
=
2
Let X denote the gain of this game. Then the expected gain is
1 1 1 1
E[ X ] = · 2 + · 4 + · 8 + · 16 + · · · = +∞
2 4 8 16
∞ ∞
k 1 k
E[ X ] = ∑ 2 ( ) = ∑ 1 = 1 ∗ ∞ = ∞
k =1
2 k =1
Assuming the game can continue as long as the coin toss results in heads and, in
particular, that the casino has unlimited resources, the expected gain is infinity.
Considering only the expected value of the net change in the player’s monetary
wealth, the player should enter the game at any price if offered the opportunity.
This is known as “St. Petersbug paradox”.

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 Bernoulli suggests that, instead of computing the expectation of the monetary out-
comes, we should value outcomes according to the “expected utility”they provide.
Most human beings do not extract utility from wealth. Rather, they extract utility
from consuming goods that can be purchased with this wealth.
The main insight of Bernoulli is to suggest that there is a nonlinear relationship
between wealth and the utility of consuming this wealth.
What ultimately matters for the decision maker ex post is how much satisfaction we
can achieve with the monetary outcome, rather than the monetary outcome itself.

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 Utility functional
Let U be a map that assigns a real number to every lottery.
We say that U is a utility functional for the preference relation  if for every
pair of lotteries A and B, we have
U ( A) ≥ U ( B) if and only if A  B.
In the case of state independent preference relations, U can be seen as a map that
assigns a real number to every probability measure on the set of possible outcomes,
i.e., U : P → R.
We say that a utility functional U has Expected Utility form if there exists a
utility function u : R → R such that for every lottery A
U ( A) = E[u( X )]
with X a random variable taking values on the set of possible outcomes of the
lottery A.
Often we will not distinguish between the lottery A and (the distribution of) the
random variable X.

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 The relationship between the monetary outcome and the degree of satisfaction is
characterized by a utility function u, which for every wealth level x tells us the level
of “satisfaction” or “utility” u( x ) attained by the agent with this wealth.
This level of satisfaction derives from the goods and services that the decision maker
can purchase with a wealth level x.
Outcomes are usually “objective”. However, their utility is “subjective” and specific
to each decision maker, depending upon their tastes and preferences.
Although the function u transforms the objective result x into a perception u( x )
by the individual, this transformation is assumed to exhibit some basic properties of
rational behavior.
For example, a higher level of x (more wealth) should induce a higher level of utility:
the function u( x ) should be increasing in x.

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 Exercise
Assume that the “satisfaction” of the player in the casino game of the St. Petersburg
paradox is determined by one of the following utility functions

1. u( x ) = x β , x > 0, β 6= 0
2. u( x ) = ln x, x > 0

In which cases is the expected utility from the gain E[u( X )] finite ?

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 St. Petersburg Paradox revisited
Let X denote the gain of the game in the St. Petersburg Paradox. Then the expected
utility from the gain if u( x ) = ln( x ) is
U ( A) = E[u( X )]
∞
= ∑ u( xk ) pk
k =1
∞
1
= ∑ ln 2 k k

k =1
2
∞
k
= (ln 2) ∑ k < +∞
k =1
2

This is caused by the ’diminishing marginal utility of money’, i.e., by the fact that
ln( x ) grows slower and slower for large x.

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 Certainty Equivalent
The Certainty Equivalent (CE) of a lottery A is the non-random payoff that
gives the same utility as playing the lottery A.
We can think of certainty equivalent as the maximal amount that an individual is
willing to pay for that lottery.
Thus, we are indifferent to the choice of receiving CE with certainty or accepting
the outcome of the lottery.
If preferences are represented by expected utility, the certainty equivalent is defined
by the following equation
u(CE[ A]) = E[u( A)]

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 Risk Aversion
An agent with preferences represented by expected utility is said to be

1. Risk-averse if CE[ A] ≤ E( A)
2. Risk-neutral if CE[ A] = E( A)
3. Risk-seeking if CE[ A] ≥ E( A)

for every lottery A.

Then, an investor is risk-averse (resp. risk-seeking) if is indifferent to the choice of
receiving a non-random payoff CE with certainty or investing in a lottery with an
expected payoff larger (resp. smaller) than CE.
The figure in the next slide shows the CE for a risk-averse agent with a lottery A
that takes only two values x1 and x2 with probabilities p and 1 − p respectively.

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 𝑢(𝑥2 )

𝑢(𝐸[𝐴]) = 𝑢(𝑝𝑥1 + 1 − 𝑝 𝑥2 )

𝐸𝑢 𝐴 = 𝑝𝑢(𝑥1 ) + 1 − 𝑝 𝑢(𝑥2 )

𝑢(𝑥1 )

𝑥1 𝐶𝐸[𝐴] 𝐸 𝐴 = 𝑝𝑥1 + 1 − 𝑝 𝑥2 𝑥2

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 Risk aversion and concave utility functions
Recall a function u : R → R is said to be concave (resp. convex) on the interval
( a, b) (which might be R) if for all x1, x2 ∈ ( a, b) and λ ∈ (0, 1) the following
inequality holds
λu( x1 ) + (1 − λ)u( x2 ) ≤ u(λx1 + (1 − λx2 )) (resp. ≥)
u strictly concave (resp. strictly convex) if the above inequality is always strict
(for x1 6= x2)

Proposition Let u be an utility function representing the preferences of an agent. If

u is strictly concave (resp. convex), then the agent is risk-averse (resp. risk-seeking).

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 Home Insurance
Let us consider a decision about buying a home insurance. There are basically two
possible outcomes

Nothing bad happens to our house, in which case our wealth is diminished by
the price of the insurance (if we decide to buy one)
Disaster strikes, our house is destroyed (by fire, earthquake etc.) and our wealth
gets diminished by the value of the house (if we do not buy an insurance) or
only by the price of the insurance (if we buy one)

This decision problem can be formulated as choosing one of the following lotteries
A and B
Probability 1 − p p Probability 1 − p p
A= B=
Final wealth w w − v Final wealth w − r w − r

p = probability that the house is destroyed, w = initial wealth

v = value of the house, r = price of the insurance

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 Home Insurance
Since the insurance wants to make money, we can be quite sure that r > pv so that
E( A) > E( B). Then, the expected return as criterion would therefore suggest not
to buy an insurance.
Let us compute the expected utility for both lotteries
U ( A) =(1 − p)u(w) + pu(w − v)
U ( B) =(1 − p)u(w − r ) + pu(w − r ) = u(w − r )
Notice that U ( A), as a function of p ∈ [0, 1], is the straight line connecting the
points (w − v, u(w − v)) and (w, u(w)).
Assume u is strict concave as in the figure on next slide.
We see that, the more concave is u, U ( B) > U ( A) for more values of p ∈ [0, 1].
That is, it becomes more advantageous to buy the home insurance.

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 𝑢(𝑤)

𝑢(𝑤 − 𝑟)

𝑝𝑢(𝑤 − 𝑣) + 1 − 𝑝 𝑢(𝑤)

𝑢(𝑤 − 𝑣)

𝑤−𝑣 𝑤−𝑟 𝑤

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 Measuring Risk Preferences
How do we capture the differences on risk aversion with the utility function and
hence compare risk attitudes across individuals:
Absolute risk aversion: Measures absolute gains and losses from current wealth.
For a twice differentiable utility function u,
u00 ( X )
ARA( x ) = − 0
u (x)

Relative risk aversion: Measures percentage gains and losses from current wealth.
u00 ( X )
RRA( x ) = − 0 x
u (x)
The numerator in the expressions indicate the concavity of the function; more conca-
ve utility functions should indicate a greater degree of risk aversion. The denominator
guarantees that the measure is invariant to affine transformations αu( x ) + β.

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 Comparing risk aversion
An agent with utility function u1 is more risk-averse than an agent with utility
function u2 if and only if the following holds:

CE1 ( L) ≤ CE2 ( L) for any lottery L.

ARA1 ( x ) ≥ ARA2 ( x ) ∀ x > 0.
There exist a concave function Ψ() such that u1 ( x ) = Ψ(u2 ( x )).

( x ) = ln( x ) is more risk

Example, show that and individual with utility function up
averse than an individual with utility function u( x ) = ( x ). Use a lottery that
pays 1000 with probability 1/2 and 500 with probability 1/2.

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