ECF350/BAS430

o An introduction
o Absolute dominance
o First order dominance and utility theory
o Second-order dominance and utility theory
o Key findings in behavioral finance.

Readings: (1) Haim Levy (2016) Chapter 3

(2) CT8 Exam Prep Manual Unit 3
 Stochastic Dominance (SD) is the partial ordering
among random variables
 It is a fundamental concept in decision theory with
uncertainty
 It describes when a particular random prospect, say
a lottery, is “better” than another random prospect
based on preferences regarding outcomes (which
may be expressed in terms of monetary values or
utility values)
 In what sense(s) can we say X ≤ Y , where X and Y
are 2 random variables?
 The simplest case of stochastic dominance is
statewise dominance (AKA state-by-state
dominance)
Definition: State by State Dominance
 Let A and B be two random variables. Then A is
statewise dominant over B if A gives at least as
good a result in every state (every possible set of
outcomes), and a strictly better result in at least one
state than B.
 Absolute dominance exists when one investment
portfolio provides a higher return than another in all
possible circumstances
Definition: Absolute Dominance
 Let X and Y be two random variables. Y is absolutely
dominant over X if 𝑃 𝑋 ≤ 𝑌 = 1 and that there is at
least one 𝑦 such that 𝐹𝑌 (𝑦) < 𝐹𝑋 (𝑦)
 However, it is possible that the other investment
could be at least at good as the first one hence, we
focus on stochastic dominance
 When a study is conducted, something is measured
 This “something” is called a random variable
Definition: Random Variable
 A random variable is a function which assigns a real
number to each point in a sample space
Example 1:
 You toss a coin two times. Let X be a number of
heads obtained, then X is a random variable and
X=0,1,2
i.e. 𝑆 = 𝑇𝑇, 𝑇𝐻, 𝐻𝑇, 𝐻𝐻
Example 2:
 If you throw two dice. Let Y be the sum of the
scores, then Y is a random variable and 𝑌 =
2,3,4, … , 11,12
i.e. 𝑆 = 1,1 , 1,2 , 1,3 , … , (6,6)
Note: We generally denote random variables by capital
letters (X, Y, etc) and denote the actual values or
observed values taken by random variables by small
letters (𝑥, 𝑦, 𝑒𝑡𝑐)
 Thus if X represents the number of heads obtained
when a coin is tossed twice then we write 𝑃(𝑋 = 𝑥)
is the probability that the number of heads is 𝑥
 i.e 𝑃 𝑋 = 0 = 1 4 , P X = 1 = 2 4 , 𝑃 𝑋 = 2 = 1 4
 The above is usually written as

𝒙 𝟎 𝟏 𝟐
𝑃(𝑋 = 𝑥) 1 2 1
4 4 4
 Note that random variables are classified into
discrete and continuous
Definition: Discrete Random Variable
 If the set of all possible values of a random variable
X is a countable set, say 𝑥1 , 𝑥2 , 𝑥3 , … , 𝑥𝑛 , then X is a
discrete random variable
 The function written as
𝑓 𝑥 =𝑃 𝑋=𝑥 , 𝑥 = 𝑥1 , 𝑥2 , 𝑥3 , …
is called the probability mass function (p.m.f) or
probability function of X
 A function 𝑓(𝑥) is a probability function if
 𝑓 𝑥𝑖 ≥ 0, 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑥𝑖
 𝑎𝑙𝑙 𝑥𝑖 𝑓 𝑥𝑖 = 1
Example 1
 Toss a coin two times. Let X be the number of heads
obtained. Find the probability function of X.
Solution
 𝑆 = 𝑇𝑇, 𝑇𝐻, 𝐻𝑇, 𝐻𝐻
 𝑋 = 0,1,2

 i.e 𝑃 𝑋 = 𝑥 ≥ 0 and we also see that

 𝑎𝑙𝑙 𝑥 𝑃(𝑋 = 𝑥) = 1
Example 2
 Suppose that the probability function of a discrete
random variable Y is given by
𝑓 𝑦 = 𝐶𝑦 2 , for y = 0,1,2,3,4
Find the value of the constant C
Solution
What we have is

y 0 1 2 3 4
f(y) 0 C 4C 9C 16C
Solution Con’t

𝑓(𝑦) = 1
𝑎𝑙𝑙 𝑦

0 + 𝐶 + 4𝐶 + 9𝐶 + 16𝐶 = 1
30𝐶 = 1

1
𝐶=
30
Example 3
 The probability function of a discrete random
variable X is given by
𝑥
3
𝑃 𝑋=𝑥 =a , for 𝑥 = 0,1,2,3, …
4
Find the value of the constant a
Solution

𝑃(𝑋 = 𝑥) = 1
𝑎𝑙𝑙 𝑥
3 1 3 2 3 3
𝑎+𝑎 4
+𝑎 4
+𝑎 4
+⋯=1

𝑎
=1
1 − 34

𝑎 1
=1 ⇒𝑎=
1 4 4
Definition: Cumulative Distribution Function
 The cumulative distribution function (cdf) of a
random variable X is defined as
𝐹 𝑥 = 𝑃(𝑋 ≤ 𝑥)
Theorem
 A function 𝐹 𝑥 is a cumulative distribution function
(cdf) for some random variable X if it satisfies the
following conditions
 Condition 1
lim 𝐹 𝑥 = 0
𝑥→−∞
 Condition 2
lim 𝐹 𝑥 = 1
𝑥→∞
 Condition 3: F(x) is right continuous
lim+ 𝐹 𝑥 + ℎ = 𝐹(𝑥)
ℎ→0

 Condition 4: F(x) is a non- decreasing function

𝐼𝑓 𝑎 < 𝑏 𝑡ℎ𝑒𝑛 𝐹(𝑎) ≤ 𝐹(𝑏)
Note
 If X is a discrete random variable, then
a) 𝐹 𝑥 is a step function
b) 𝑃 𝑎 < 𝑋 ≤ 𝑏 = 𝐹 𝑎 − 𝐹(𝑏)
Example
 The probability distribution for a random variable X
is given by
x 1 2 3 4 5 6
f(x) 0.1 0.1 0.2 0.4 0.15 0.05
 Find
i. The cdf of X and sketch its graph
ii. 𝑃 𝑋 ≥ 4
iii. 𝑃(2 < 𝑋 ≤ 4)
Solution
i. 𝐹 𝑥 = 𝑃(𝑋 ≤ 𝑥)
𝐹 1 = 𝑃 𝑋 ≤ 1 = 𝑃 𝑋 = 1 = 0.1
𝐹 2 = 𝑃 𝑋 ≤ 2 = 𝑃 𝑋 = 1 + 𝑃 𝑋 = 2 = 0.1 + 0.1 = 0.2
And so on for all six values
This can then be presented as

x 1 2 3 4 5 6
F(x) 0.1 0.2 0.4 0.8 0.95 0.1

or
Solution
0, 𝑥<1
0.1, 1≤𝑥<2
0.2, 2≤𝑥<3
𝐹 𝑥 = 0.4, 3≤𝑥<4
0.8, 4≤𝑥<5
0.95, 5≤𝑥<6
1, 𝑥≥6

Follow the Sketch in class

Solution
ii. 𝑃 𝑋 ≥ 4 = 𝑃 𝑋 = 4 + 𝑃 𝑋 = 5 + 𝑃(𝑋 = 6)
= 0.4 + 0.15 + 0.05
= 0.6
iii. 𝑃 2 < 𝑋 ≤ 4 = 𝐹 4 − 𝐹 2 = 0.8 − 0.2 = 0.6

or

𝑃 2 < 𝑋 ≤ 4 = P X = 3 + P X = 4 = 0.2 + 0.4 = 0.6

Definition: Continuous Random Variable
 If a random variable X takes values on an interval or
intervals (i.e. on continuous set of values) then X is
said to be a continuous random variable
Note:
1. 𝑃 𝑋 = 𝑥 = 0 for any continuous random variable
2. A continuous random variable is specified by its
probability density function (pdf)
Definition: Probability Density Function (p.d.f)
 A function 𝑓 𝑥 is a probability density function
(p.d.f) for some random variable X if
1. 𝑓(𝑥) ≥ 0 for all values of x
2. 𝑓 𝑥 𝑑𝑥 = 1 for all values of x
Note
 If X is a continuous random variable with p.d.f 𝑓(𝑥)
over the interval 𝑥1 ≤ 𝑥 ≤ 𝑥2 , then
𝑏
a) 𝑃 𝑎 ≤ 𝑋 ≤ 𝑏 = 𝑎
𝑥 𝑑𝑥, where 𝑥1 ≤ 𝑎 < 𝑏 ≤ 𝑥2
𝑓
b) 𝑃 𝑎 ≤ 𝑋 ≤ 𝑏 = 𝑃 𝑎 ≤ 𝑋 < 𝑏 = 𝑃 𝑎 < 𝑋 ≤ 𝑏 =
𝑃 𝑎 < 𝑋 < 𝑏 = 𝐹 𝑏 − 𝐹(𝑎)
Definition: Cumulative Distribution Function (c.d.f)
 If 𝑓 𝑥 is a p.d.f of a continuous random variable X
defined over the interval −∞ < 𝑥 < ∞ , then the
cumulative distribution function (c.d.f) of X is
defined as
𝑥

𝐹 𝑥 = 𝑓 𝑡 𝑑𝑡 = 𝑃(𝑋 ≤ 𝑥)
−∞
Note
 If X is a continuous random variable with p.d.f 𝑓(𝑥)
𝑑
and c.d.f. 𝐹 𝑥 , then 𝑓 𝑥 = 𝐹(𝑥)
𝑑𝑥
Example
A continuous random variable has p.d.f.
𝑓 𝑥 = 𝑘𝑥 2 , −1 < 𝑥 < 2
Find
a) The value of the constant k
b) The c.d.f of X
c) 𝑃(0 < 𝑋 ≤ 1)
Solution
a) 𝑓 𝑥 𝑑𝑥 = 1, for all values of x
2 2 𝑑𝑥 = 1
−1
𝑘𝑥
𝑘𝑥 3 2
⇒ =1
3 −1
𝑘
⇒ 8 − (−1) =1
3
𝑘
⇒ 9 =1
3
⇒ 3𝑘 = 1
1
⇒𝑘=
3
Solution
𝑥
b) 𝐹 𝑥 = −∞
𝑓(𝑡) 𝑑𝑡
2 1 2 𝑑𝑡
= −1 3
𝑡
1 𝑡3 𝑥
=
3 3 −1
1
= 𝑥 3 − −1 3
9
1
= 𝑥3 + 1
9
Solution
b) Continues

0, 𝑥 ≤ −1
𝑥3 + 1
𝐹 𝑥 = , −1 < 𝑥 ≤ 2
9
1, 𝑥>2
Solution
c) 𝑃 0 < 𝑋 ≤ 1 = 𝐹 1 − 𝐹 0

1+1 0+1
= −
9 9
2 1
= −
9 9

1
=
9
Solution
c) Continues
or
11 3
𝑃 0<𝑋≤1 = 0 3
𝑥 𝑑𝑥

𝑥3 1
=
3 0

1
= −0
9

1
=
9
TASK
A continuous random variable X has pdf

𝑘𝑥, 0<𝑥<1
𝑓 𝑥 = 𝑘 2 − 𝑥 ,1 ≤ 𝑥 < 2
0 𝑒𝑙𝑠𝑒𝑤ℎ𝑒𝑟𝑒
Find
a) The value of the constant k
b) The c.d.f of X
c) 𝑃(1 2 < 𝑋 < 1)
d) 𝑃(0 < 𝑋 < 3 2)
Solution
a) 𝑓 𝑥 𝑑𝑥 = 1, 𝑓𝑜𝑟 𝑎𝑙𝑙 𝑣𝑎𝑙𝑢𝑒𝑠 𝑜𝑓 𝑥
1 2
⇒ 0
𝑘𝑥𝑑𝑥 + 1
𝑘(2 − 𝑥)𝑑𝑥 = 1

𝑘𝑥 2 1 𝑥2 2
⇒ +𝑘 2𝑥 − =1
2 0 2 1

𝑘 1
⇒ +𝑘 4−2 − 2− =1
2 2

𝑘 𝑘
⇒ + =1
2 2
⇒𝑘=1
Solution
𝑥
b) 𝐹 𝑥 = −∞
𝑓 𝑡 𝑑𝑡
𝑥 𝑘𝑡 2 𝑥
⇒ 𝐹1 𝑥 = 𝑘𝑡 𝑑𝑡 = , 𝑏𝑢𝑡 𝑘 = 1
0 2 0

𝑡2 𝑥 𝑥2
= = ,0 < 𝑥 < 1
2 0 2
𝑥
𝐹2 𝑥 = 𝐹1 1 + 1 (2 − 𝑡) 𝑑𝑡
1 𝑡2 𝑥 𝑥2
= + 2𝑡 − = 2𝑥 − − 1, 1≤𝑥<2
2 2 1 2
Solution
b) Continues

0, 𝑥≤0
𝑥2
, 0<𝑥<1
𝐹 𝑥 = 2
𝑥2
2𝑥 − − 1, 1≤𝑥<2
2
1, 𝑥≥2
Solution
1 1
c) 𝑃 2 <𝑋 <1 =𝐹 1 −𝐹
2
3 3
d) 𝑃 0 < 𝑋 < =𝐹 −𝐹 0
2 2
In the case of two variables or joint distributions, the
c.d.f of X and Y is given by
F(𝑥, 𝑦) = 𝑃 𝑋 ≤ 𝑥, 𝑌 ≤ 𝑦 𝑓𝑜𝑟 𝑎𝑙𝑙 (𝑥, 𝑦) ∈ ℝ2
Properties
i. F is non-decreasing in x for fixed y
ii. F is non-decreasing in y for fixed x
iii. lim 𝐹 𝑥, 𝑦 = lim 𝐹 𝑥, 𝑦 = 0
𝑥→−∞ 𝑦→−∞
iv. lim 𝐹 𝑥, 𝑦 = 1
(𝑥,𝑦)→(∞,∞)
Definition: Marginal c.d.f
The marginal c.d.f of X is given by
𝐹𝑋 𝑥 = 𝑃 𝑋 ≤ 𝑥 = lim 𝐹 𝑥, 𝑦 , 𝑥∈ℝ
𝑦→∞

Similarly,
The marginal c.d.f of Y is given by
𝐹𝑌 𝑦 = 𝑃 𝑌 ≤ 𝑦 = lim 𝐹 𝑥, 𝑦 , 𝑦∈ℝ
𝑥→∞
Definition: Joint p.d.f of discrete random Variables
If X and Y are discrete random variables, then the joint
probability function of X and Y is given by
𝑓 𝑥, 𝑦 = 𝑃 𝑋 = 𝑥, 𝑌 = 𝑦 , (𝑥, 𝑦) ∈ ℝ2
Properties
i. 𝑓 𝑥, 𝑦 ≥ 0, for (𝑥, 𝑦) ∈ ℝ2
ii. 𝑓 𝑥, 𝑦 = 1, for all (𝑥, 𝑦) ∈ ℝ2
Definition: Joint p.d.f of continuous random Variables
If X and Y are discrete random variables, then the joint
probability function of X and Y is given by
𝑓 𝑥, 𝑦 = 𝑃 𝑋 = 𝑥, 𝑌 = 𝑦 , (𝑥, 𝑦) ∈ ℝ2
Properties
i. 𝑓 𝑥, 𝑦 ≥ 0, for (𝑥, 𝑦) ∈ ℝ2

ii. 𝑎𝑙𝑙𝑥 𝑎𝑙𝑙𝑦

𝑥, 𝑦 = 1 for all (𝑥, 𝑦) ∈ ℝ2
Definition: FSD
 Let X and Y be two random variables. Y is first order
stochastically dominant over X if 𝐹𝑌 (𝑦) ≤ 𝐹𝑋 (𝑦) and
that there is at least one 𝑦 such that 𝐹𝑌 (𝑦) < 𝐹𝑋 (𝑦)
 If Y stochastically dominate X we write 𝑌 ≥𝑆𝐷 𝑋 or
X ≤𝑆𝐷 𝑌
 State dominance makes greater use of the
probability functions, probability density functions
and cumulative probability functions
 The pair (x,p(x)) where x is the outcome and p(x) is
its corresponding probability is called a probability
function
 If the random variable x is continuous, then the
 probability function is replaced by the density
function f(x)
 The cumulative probability function for a discrete
distribution denoted by F(x) is given by
𝐹 𝑥 =𝑃 𝑋≤𝑥 = 𝑃(𝑥)
𝑋≤𝑥
 The cumulative probability function for a continuous
random variable denoted by F(x) is given by

𝐹 𝑥 = 𝑓 𝑡 𝑑𝑡
−∞
 The cumulative probability function for a discrete
distribution denoted by F(x) is given by
𝐹 𝑥 =𝑃 𝑋≤𝑥 = 𝑃(𝑥)
𝑋≤𝑥
 The cumulative probability function for a continuous
random variable denoted by F(x) is given by

𝐹 𝑥 = 𝑓 𝑡 𝑑𝑡
−∞
 In portfolio theorem, let A and B be two different
portfolios. The FSD states that assuming an investor
prefers more to less, A will dominate B (i.e. the
investor will prefer Portfolio A to Portfolio B) if:
 𝐹𝐴 (𝑥) ≤ 𝐹𝐵 (𝑥), for all values of x, and
 𝐹𝐴 𝑥 < 𝐹𝐵 (𝑥), for some values of x
 This means that the probability of Portfolio B
producing a return below a certain value is never
less than the probability of Portfolio A producing a
return below the same value and exceeds it for at
least some value of x
 Using measures of central tendency and dispersion,
we are saying that if two normal distributions have
the same variance but different means, the one
with the higher mean displays first-order stochastic
dominance over the other
 Graphically, if A is first-order stochastically dominant
over B and that A and B are discrete, then we show
the following

𝐹𝐵 (𝑥)

𝐹𝐴 (𝑥)
 Graphically, if A is first-order stochastically dominant
over B and that A and B are continuous, then we
show the following
 Consider two assets, A and B with the following
respective returns in different outcomes, “good” of
“poor” investment outcomes
Asset A Asset B
Good Outcome 6% 10%
Poor Outcome 5% 8%

 Asset B produces higher returns in either outcome

 Given that more is preferred to less, asset B
absolutely dominate asset A
 Assume now that our assets have outcomes with
associated probabilities as shown below
Asset A Asset B
Return Prob Return Prob
7% 0.5 8% 0.5
5% 0.5 6% 0.5

 To determine which asset an investor will choose, we

rely on the theorem of stochastic dominance
 This is because it is highly uncertain which asset will
have higher returns
 Cumulative prob distribution
Return Asset A Asset B
5% 0.5 0
6% 0.5 0.5
7% 1 0.5
8% 1 1

 It is clear that
 𝐹𝐵 (𝑥) ≤ 𝐹𝐴 (𝑥), for all values of x, and
 𝐹𝐵 𝑥 < 𝐹𝐴 (𝑥), for some values of x
 Hence, asset B first-order state dominate asset A
 An investor should choose asset B
 Graphically, Asset B is first-order stochastically
dominant over B and thus the graph for asset B will
lie below that of asset A as seen below

𝐹𝐴 (𝑥)

𝐹𝐵 (𝑥)
Task
Consider two risky assets A and B. A yields ZMW1 with
probability 1 4 and ZMW2 with probability 3 4 . B
yields ZMW1 with probability 1 2 and ZMW2 with
probability 1 2.
a) Which asset should the investor choose?
b) What would you say about asset C, which yields
ZMW1 with probability 1 4 and ZMW3 with
probability 3 4?
Solution
Probability c.d.f
Return A B C A B C
ZMW1 1 4 1 2 1 4 1 4 1 2 1 4
ZMW2 3 4 1 2 0 1 1 1 4
ZMW3 0 0 3 4 1 1 1

a) A is first-order stochastically dominant over B because

 𝐹𝐴 (𝑥) ≤ 𝐹𝐵 (𝑥), for all values of x, and
 𝐹𝐴 𝑥 < 𝐹𝐵 (𝑥), for some values of x
A can be obtained from B by shifting a probability of ¼
from the ZMW1 outcome to the higher ZMW2 outcome
Solution
b) C is first-order stochastically dominant over A because
 𝐹𝐶 (𝑥) ≤ 𝐹𝐴 (𝑥), for all values of x, and
 𝐹𝐶 𝑥 < 𝐹𝐴 (𝑥), for some values of x
C is also first-order stochastically dominant over B
because
 𝐹𝐶 (𝑥) ≤ 𝐹𝐵 (𝑥), for all values of x, and
 𝐹𝐶 𝑥 < 𝐹𝐵 (𝑥), for some values of x
C can be obtained from A by shifting a probability of
3 4 from the ZMW2 outcome to the higher ZMW3
outcome
Solution
b) Continues
C can also be obtained from B by shifting a probability
of 1 4 from the ZMW1 outcome to the higher ZMW2
outcome

Note that,
 FSD is transitive
 Hence, 𝐶 > 𝐴 > 𝐵
 FSD is just a necessary condition for choice but not a
sufficient condition
Definition: SSD for Discrete Random Assets
 Let A and B be two assets. Then A is said to be
second order stochastically dominant over B if
a) 𝐹𝐴 (𝑦) ≤ 𝐹𝐵 (𝑦) , for all values of x
b) 𝐹𝐴 (𝑦) < 𝐹𝐵 (𝑦) , for for some values of x
Definition: SSD for continuous Random Assets
 Let A and B be two assets. Then A is said to be
second order stochastically dominant over B if
𝑥 𝑥
a) 𝐹
𝑎 𝐴
𝑦 𝑑𝑦 ≤ 𝐹
𝑎 𝐵
𝑦 𝑑𝑦 , for all values of x
𝑥 𝑥
b) 𝐹
𝑎 𝐴
𝑦 𝑑𝑦 < 𝐹
𝑎 𝐵
𝑦 𝑑𝑦 , for for some values of x

 Note that a in the above integrals is the lowest

return that the portfolio can possibly provide
 It must be noted here that the second-order
stochastic dominance theorem applies when the
investor is risk averse, as well as preferring more to
less
 i.e. 𝑈 ′′ (𝑤) < 0 and that 𝑈 ′ 𝑤 > 0

 This then implies that a potential gain of a certain

amount is not valued as highly as a loss of the same
amount
 i.e. a risk-averse investor will accept a lower
probability of a given extra return at a low absolute
level of return in preference to the same probability
of extra return at a higher absolute level
 In the case of the measures of central tendency and
dispersion, if two normal distributions have the same
mean but different variances, the one with the lower
variance displays second-order stochastic dominance
over the other
Example
 Consider two assets, asset A and asset B with the
respective returns and probabilities below.
a) Which assets should an investor choose based on FSD?
b) Which assets should an investor choose based on SSD?
Probability
Return Asset A Asset B
6% 0.25 0
7% 0.25 0.75
8% 0.25 0
9% 0.25 0.25
Solution
a) . c.d.f.
Return Asset A Asset B
6% 0.25 0
7% 0.5 0.75
8% 0.75 0.75
9% 1 1

The choice between the two assets cannot be made

using FSD because no asset dominates the other.
𝐹𝐴 6 > 𝐹𝐵 6 𝑏𝑢𝑡 𝑤𝑒 𝑠𝑒𝑒 𝐹𝐴 7 < 𝐹𝐵 7
Solution
b) . 𝒄. 𝒅. 𝒇.
Return Asset A Asset B
6% 0.25 0
7% 0.75 0.75
8% 1.5 1.5
9% 2.5 2.5
Following SSD, the investor should choose asset B since
asset B is second order stochastically dominant over
asset A. i.e.
a) 𝐹𝐵 (𝑦) ≤ 𝐹𝐴 (𝑦) , for all values of x
b) 𝐹𝐵 (𝑦) < 𝐹𝐴 (𝑦) , for for some values of x
Solution
b) . 𝒄. 𝒅. 𝒇.
Return Asset A Asset B
6% 0.25 0
7% 0.75 0.75
8% 1.5 1.5
9% 2.5 2.5

According to the second-order stochastic dominance

theorem, the investor should therefore always choose
Asset B – which offers the same expected return as
Asset A but with a lower variance.
Class Task
 Consider two assets, asset A and asset B with the
respective returns and probabilities below.
a) Which assets should an investor choose based on FSD?
b) Which assets should an investor choose based on SSD?
Asset A Asset B
Outcome Probability Outcome Probability
2 1 3 3 1 3
4 1 3 4 1 3
7.5 1 3 6.5 1 3
Solution
a) . c.d.f.
Outcome Asset A Asset B
2 1 3 0
3 1 3 1 3
4 2 3 2 3
6.5 2 3 1
7.5 1 1

The choice between the two assets cannot be made

using FSD because no asset dominates the other.
𝐹𝐴 2 > 𝐹𝐵 2 𝑏𝑢𝑡 𝑤𝑒 𝑠𝑒𝑒 𝐹𝐴 6.5 < 𝐹𝐵 6.5
Solution 𝒄. 𝒅. 𝒇.

b) . Outcome Asset A Asset B

2 1 3 0
3 2 3 1 3
4 4 3 1
6.5 2 2
7.5 3 3
Following SSD, the investor should choose asset B since
asset B is second order stochastically dominant over
asset A. i.e.
a) 𝐹𝐵 (𝑦) ≤ 𝐹𝐴 (𝑦) , for all values of x
b) 𝐹𝐵 (𝑦) < 𝐹𝐴 (𝑦) , for for some values of x
Advantage
 it does not require explicit formulation of the
investor’s utility function, but can instead be used to
make investment decisions for a wide range of utility
functions
Disadvantages
 may be unable to choose between two investments
and
 It generally involves pair-wise comparisons of
alternative investments, which may be problematic if
there is a large number of investments between
which to choose
Citations
 Hens, T., & Rieger, M. O. (2016). Financial
Economics: A Concise Introduction to Classical and
Behavioral Finance (2nd ed.). Berlin: Springer.

 The Faculty of Actuaries and Institute of Actuaries,

Subject CT8: Financial Economics, Core Technical.
Core reading for the 2016 Examinations