AP

Week 1
CRRA Utility Function

Antonio Guarino
 Constant Relative Risk Aversion (CRRA)

Suppose you propose to a client to invest 10% of his wealth in a risky

asset, say a stock. If the company is profitable, the investor will have a
gross return R=3 so that his wealth W will become W+0.2W; if however
the company turns out not to be profitable, the investor will lose his
money, so that his wealth will become W-0.1W.

Question: do you think the investor will be more willing to invest in this
asset if he is “poor” (low W) or “rich” (high W).
 Constant Relative Risk Aversion (CRRA)

There is no unique answer to this question. Preferences are subjective.

Do not try to impose your preferences on your client!

In this example, it seems plausible to think that two opposite forces are
at work:
- The higher W, the more one could be inclined to take risk;
- The higher W, the higher the amount 0.1W that one has to invest,
which may make the investor less inclined to take risk.
 The Formula for CRRA

With the CRRA utility function, we represent the preferences of

investors whose willingness to take this type of risk id independent of
W.

$%&' ()
! " = )('
for ' ≠ 1

!(")=lnW for '=1

 Constant Relative Risk Aversion (CRRA) and R(W)

With the CRRA utility function, the index of relative risk aversion is
independent of wealth:

! " =$
Key Points

• Investor whose willingness to accept a “relative bet” is independent of W;

• CRRA and R(W).