PORTFOLIO AND INVESTMENT AYY / APRIL 14TH 2021

ANALYSIS
 CHAPTER 2: RATIONAL CHIOCE THEORY (WEEK 2-3)

TOPIC 1: UTILITY FUNCTIONS

TOPIC 2 : INVESTMENT OPPORTUNITIES UNDER UTILITY FUNCTIONS
OBJECTIVE OH THIS CHAPTER: TOPIC 2
(WEEK 3)
Discuss how a utility function may depend on current wealth
and discuss state dependent utility functions.
Perform calculations using commonly used utility functions to
compare investment opportunities.
Analyze simple insurance problems in terms of utility
theory.
THE VARIATION OF UTILITY FUNCTIONS WITH WEALTH
State-dependent utility functions

• State-dependent utility functions used to model the situation where there is a

discontinuous change in the state of the investor at a certain level of wealth
• the utility derived from wealth may reflect existing financial state and general
circumstances
• a sophisticated utility function constructed by combining one or more of the
standard functions — so that a different utility function effectively applies over
different levels of wealth

Case study:
Consider an insurance company that will become insolvent if the value of its assets
fails below a certain level. What would be the model of utility function related to
risk preference?

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THE VARIATION OF UTILITY FUNCTIONS WITH WEALTH
• At asset levels just above the insolvency position, the company will be highly risk-
averse -> modelled by a utility function that has a discontinuity at the insolvency
point.
• However, if we apply the same utility function when the company has just become
insolvent -> the company would be prepared to accept a high probability of losing
its remaining assets for a chance of regaining solvency.
• at the point of becoming (technically) insolvent the company is very risk-averse,
being very keen to avoid this happening
• Should it become (technically) insolvent, it may then be willing to take more risks in
order to regain solvent status.

This is unlikely to reflect reality and so a different form of utility function

would be required to model the company's behaviour in this state.

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THE VARIATION OF UTILITY FUNCTIONS WITH WEALTH
The utility function of the above company.
U(w)

solvency level

the company is extremely risk-averse when just solvent, so the curve has a rapidly
changing gradient. At the solvency level the curve is vertical as any slight increase in
wealth leads to a large jump in utility.

Utility functions are determined by the level of wealth

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CONSTRUCTION OF UTILITY FUNCTIONS
• This subtopic will show how a utility function can be constructed in general
• calibrate the function (find parameters) to represent the particular individual utility

1. Construction of utility functions by direct questioning

• simply ask the individual what is their utility function
• most unlikely to describe the mathematical form of their utility function.

2. Construction of utility functions by indirect questioning

• 1st: fixing two values of the utility function for the two extremes of wealth being
considered
• 2nd: the individual is asked to identify a certain level of wealth such that he or she would
be indifferent between that certain level of wealth and a gamble that yields either of the
two extremes with particular probabilities
• The process is repeated for various scenarios until a sufficient number of plots is found.

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CONSTRUCTION OF UTILITY FUNCTIONS
Example 3:

Exercise 2:
What is the maximum that a home owner would be prepared to pay for insurance
with a given level of initial wealth and a given potential insurance situation.

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MAXIMIZING UTILITY THROUGH INSURANCE
• Utility theory can be used to explain decisions such as purchasing insurance or buying a
lottery ticket.
• Both of these activities are more likely to diminish the expected wealth of an individual.
However, by purchasing insurance, one may be maximizing expected utility.
• A person who is risk averse will be prepared to pay more for insurance than the long-run
average value of claims which will be made.

1. Finding the maximum premium

• The maximum premium, P, which an individual will be prepared to pay in order to insure
themselves against a random loss X is given by the solution of the equation:

𝐸 𝑈 𝑎−𝑋 = 𝑈 (𝑎 − 𝑃)
Where a is the initial level of wealth.

Example 4:

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MAXIMIZING UTILITY THROUGH INSURANCE
2. Finding the minimum premium
• The minimum insurance premium Q which an insurer should be prepared to charge for
insurance against a risk with potential loss Y is given by the solution of the equation:

𝐸 𝑈 𝑎+𝑄+𝑌 = 𝑈 (𝑎)
Where a is the initial level of wealth.

Exercise 3:

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THE LIMITATION OF UTILITY THEORY
• The expected utility theorem is very useful in risky decisions, because it focuses
attention on the types of trade-offs that have to be made.
• However, the expected utility theorem has several limitations that reduce its
relevance for risk management purposes:
i. To calculate expected utility, the precise form and shape of the individual's
utility function are required. However, such information is not available. The
best method is to identify a general feature, such as risk aversion, and to use
the rule to identify broad types of choices that might be appropriate.
ii. The theorem cannot be applied separately to each of several sets of risky
choices facing an individual.
iii. For corporate risk management, it may not be possible to consider a utility
function for the firm as though the firm was an individual

Alternative decision rules that can be used for risky choices include those under mean-
variance portfolio theory and stochastic dominance.

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THE END…THANK YOU AYY / MARCH 14TH 2021