Behavioural Finance: Worksheet 1

1. Alan has £100 in money and a car worth £220. Full insurance costs £51 and insurance
only against theft £23. The probability of the car being stolen or in an accident is 10%
each and the probability of being stopped by the police and asked to prove insurance
5%. The fine for driving without full insurance is £100. He has to decide whether to buy
insurance and, if so, which one.
a. What is the expected value of his wealth (x) in each case?
b. Let’s assume his utility function is U(x) = x. What is the best option and what attitude
to risk does he have?
c. Let’s assume his utility function is U ( x )=10 √ x (concave). What is the best
option and what attitude to risk does he have?
2
x
d. Let’s assume his utility function is U ( x )= (convex). What is the best option and
50
what
attitude to risk does he have
Working:
a. Case hợp 1: If he only buys full insurance, he will have a 95% profit of $51. The
probability that he loses $220 is 10% because the car could be stolen or have an accident.
Expected value is E(x1) = (-220$) x 10% + 51$ x 95% = 26.45$
 U(x1) = 0.95 x u(51) = 3.735
 U( E(x1) ) = u(26.45) = 3.275
Case 2: f he only buys anti-theft insurance, he will have a 90% profit of $23. The probability
that he will lose $100 is 5% because the police can stop the car to check the full insurance.
Expected value is E(x2) = (-100$) x 5% + 23$ x 90% = 15.7$
 U(x2) = 0.9 x u(23) = 2.822
 U( E(x2) ) = u(15.7) = 2.753
Case 3: He buys both types of insurance and will have a 95% profit of $51 and a 90% profit
of $23:
Expected value is E(x3) = 51$ x 95% +23$ x 90% = 69.15$
 U(x3) = 0.95 x u(51) + 0.9 x u(23) = 6.555
 U( E(x3) ) = u(69.15) = 4.236
Case 4: If he does not buy both types of insurance, there will be a 5% loss of $100 and a 10%
loss of $220.
Expected value là E(x4) = (-100$) x 5% + (-220$) x 10% = -27$  no prospect.
 b. Suppose his utility function is U(x) = x. So his U(x) will be 3.735; 2,822 and 6,555.
It can be seen that the function U(x3) has the largest value  The best option is to buy both types of
insurance.
Comparing, we see that the functions U(E(x)) are not significantly different from the functions
U(x)  He is a person with a neutral attitude towards risk.

c. Suppose his utility function is U(x)=10√x (concave). So his U(x) is 19.32 ; 16.79 and 25.6 It can
be seen that the function U(x3) has the largest value  The best option is to buy both types of
insurance.
Comparing we see that functions U(E(x) ) < functions U(x)  He is a risk seeker.

2
x
d. Suppose his utility function is U(x)= (convex). So his U(x) is 0.112; 0.166 and 0.859
50

It can be seen that the function U(x3) has the largest value  The best option is to buy both types
of insurance.
Comparing we see that functions U(E(x) ) > functions U(x)  He is a person who does not like
risk.

2. Using a suitable utility-wealth diagram, explain why most people are risk-averse.

Risk-averse investors are more likely to have lower returns relative to known risks than higher returns
relative to unknown risks. In other words, among different accounts that offer equal profits with different
levels of risk, this investor will always choose the safest investment level, which is a little but definitely
profitable. A risk-averse investor clearly stays away from high-risk investment accounts and prefers
investment accounts that offer solid returns. Such investors prefer to invest in government bonds,
debentures and indices.

3. Discuss the assumptions of expected utility theory.

Expected utility theory is a widely used theory in economics and decision-making that assumes individuals
make rational choices based on expected values and their utility function. However, the theory is based on
several key assumptions. Let's discuss these assumptions with an example:

Assumption 1: Rationality
Expected utility theory assumes that individuals are rational decision-makers who have well-defined
preferences and strive to maximize their personal utility or well-being. For example, let's say you have a
choice between two job offers. Job A offers a higher salary but longer working hours, while Job B offers a
lower salary but better work-life balance. The assumption of rationality suggests that you would evaluate your
preferences, weigh the pros and cons of each option, and make a decision based on which job offers the
highest expected utility given your preferences.

Assumption 2: Consistency
The theory assumes that individuals have transitive preferences, meaning if they prefer option A over option
B and option B over option C, then they also prefer option A over option C. For example, if you prefer eating
pizza over eating burgers and prefer eating burgers over eating sushi, then the assumption of consistency
suggests that you would also prefer eating pizza over eating sushi. This assumption ensures that individuals'
choices are logically consistent and do not violate basic principles of decision-making.

Assumption 3: Independence
 Expected utility theory assumes that individuals' preferences are independent of irrelevant alternatives. For
example, let's say you are choosing between two vacation destinations: Destination A and Destination B. The
assumption of independence means that the addition of a third irrelevant destination, Destination C, should not
change your ranking or preference between Destination A and Destination B. In other words, the introduction
of an irrelevant option should not influence your decision-making process.

Assumption 4: Utility Function

The theory assumes that individuals' preferences can be represented by a utility function, which assigns a
numerical value to each possible outcome or state of the world. For example, let's say you are deciding
between investing in two stocks: Stock A and Stock B. The assumption of a utility function suggests that you
can assign a numerical value to the potential returns and risks associated with each stock, and make a
decision based on which stock maximizes your utility function.

Assumption 5: Risk Attitudes

Expected utility theory assumes that individuals have consistent risk preferences and can be characterized
as risk-averse, risk-neutral, or risk-seeking. For example, let's say you are considering two investment options:
Option X with a guaranteed return of 5% and Option Y with a 50% chance of a 10% return and a 50% chance
of a 0% return. The assumption of risk attitudes suggests that, depending on your risk preference, you would
choose Option X if you are risk-averse, Option Y if you are risk-seeking, or either option if you are risk-neutral.

Assumption 6: Probabilistic Calculations

The theory assumes that individuals can assign probabilities to different outcomes or states of the world and
can accurately calculate expected values based on these probabilities. For example, let's say you are deciding
whether to buy insurance for your car. You estimate that there is a 10% chance of your car being stolen or in
an accident, and a 90% chance of it being safe. The assumption of probabilistic calculations suggests that you
would weigh the potential losses (value of the car) against their associated probabilities and calculate the
expected value of each option to make an informed decision.

It is important to note that while expected utility theory provides a useful framework for decision-making under
uncertainty, it relies on several simplifying assumptions that may not always hold in real-world situations.
Individuals may not always exhibit perfect rationality, consistent preferences, or accurate probability
assessments. Additionally, factors such as emotions, cognitive biases, and limited information can influence
decision-making in ways that deviate from the assumptions of expected utility theory.
4. Explain the Allais paradox
The Allais paradox is a well-known inconsistency in decision-making that challenges the assumptions of
expected utility theory. It was first described by the French economist Maurice Allais in the 1950s.
The paradox involves a choice between two sets of lotteries, typically referred to as "Lottery A" and "Lottery
B."
In Lottery A, there are two possible outcomes:
Outcome 1: A guaranteed prize of $1 million.
Outcome 2: A 10% chance of winning $5 million and a 90% chance of winning nothing.
In Lottery B, there are also two possible outcomes:
Outcome 3: A 11% chance of winning $1 million and an 89% chance of winning nothing.
Outcome 4: A 10% chance of winning $5 million and a 90% chance of winning nothing.
Expected utility theory suggests that individuals should evaluate lotteries based on their expected values and
their utility function. In this case, since the expected value of both lotteries is the same ($1 million), individuals
should be indifferent between Lottery A and Lottery B.
However, experimental studies have shown that a significant number of individuals exhibit a preference for
Lottery A over Lottery B. This preference violates the principle of expected utility theory and is referred to as
the Allais paradox.
The paradox arises because individuals tend to overweight the probability of winning a certain outcome
compared to the probability of winning a risky outcome. In Lottery A, individuals are attracted to the certain
outcome of winning $1 million, even though the risky outcome of winning $5 million in Lottery B has a higher
expected value.
The Allais paradox highlights the limitations of expected utility theory and suggests that individuals' decision-
making behavior may not always conform to the assumptions of rationality and consistent preferences. It has
led to the development of alternative theories, such as prospect theory, which seek to explain decision-making
under uncertainty in a more descriptive and realistic manner.
5. What other challenges to expected utility theory are there?

This essay will explore some small formulations for expected utility theory. The first is that it does not
consider fundamental economic factors that can affect interest rates and bond yields. For example, prizes
and economic growth are important factors that can significantly affect bond returns and returns, but they
are not considered in expectations theory. Second, we do not guarantee stability in expected work and
interest calculation. Financial markets can be affected by many unexpected factors, such as economic
fluctuations, policy changes, international events, and other factors. This can alter expectations and cause
interest rates to fluctuate in unpredictable ways. Ultimately, it is overvalued or undervalued in the near
future. This can lead to inaccuracies in bond yield curve predictions and pose risks to advisors.

6. Differentiate the following terms/concepts:

a. Prospect and probability distribution

b. Risk and uncertainty

c. Utility function and expected utility

d. Risk aversion, risk seeking, and risk neutrality

a. Prospect and probability distribution:

A prospect refers to a potential outcome or scenario that may occur. It is often used in decision-making
under uncertainty, where different prospects are evaluated based on their potential benefits and drawbacks.

A probability distribution, on the other hand, refers to a mathematical representation of the likelihood of
different outcomes occurring. It provides a structured way to assign probabilities to various prospects.

b. Risk and uncertainty:

Risk refers to a situation where the probabilities of different outcomes are known or can be estimated. It
involves quantifiable uncertainty, where probabilities can be assigned to different outcomes and their
potential impacts.

Uncertainty, on the other hand, refers to a situation where the probabilities of different outcomes are
unknown or cannot be estimated. It involves unquantifiable or subjective uncertainty, making it difficult to
assign probabilities or assess the potential impacts of various outcomes.

c. Utility function and expected utility:

A utility function is a mathematical representation of an individual's preferences and values. It assigns a

numerical value to different outcomes or prospects based on their desirability or satisfaction. Utility functions
are used to model decision-making under uncertainty or risk.

Expected utility is a concept that combines probabilities and utilities to determine the overall value or
desirability of a particular prospect. It involves multiplying the utility of each possible outcome by its
respective probability, and then summing up these values to obtain the expected utility of the prospect.

d. Risk aversion, risk seeking, and risk neutrality:

Risk aversion refers to a preference for lower-risk prospects or outcomes. Risk-averse individuals are more
concerned about potential losses and tend to choose options with lower potential gains but also lower
potential losses.

Risk seeking, on the other hand, refers to a preference for higher-risk prospects or outcomes. Risk-seeking
individuals are more focused on potential gains and are willing to accept higher potential losses for the
chance of higher rewards.

Risk neutrality refers to a lack of preference for risk. Risk-neutral individuals evaluate prospects purely
based on their expected values and do not consider the level of risk associated with different outcomes. They
are indifferent between options with the same expected utility, regardless of the level of risk involved.

7. When eating out, Rory prefers spaghetti over a hamburger. Last night, she had a choice of
spaghetti or macaroni and cheese and decided on the spaghetti again. The night before, Rory had a
choice of spaghetti, pizza, or a ham burger, and this time she had pizza. Then, to day, she chose
macaroni and cheese over a hamburger. Does her selection today indicate that Rory’s choices are
consistent with economic rationality? Why or why not?.

Economic rationality means that a consumer chooses that option that is economically reasonable rather than
based on emotions or ideals. Decision-making here is directly proportional to the utility or benefits derived.
In the case given above, Rory's choices are definitely according to economic rationality.
pizza>spaghetti>mì ống>Ham
If we observe her preferences are transitive, first preference is pizza then spaghetti, macaroni and cheese,
and lastly hamburger. It is not changing as per the mood and is firm and hence rational.
8. Consider a person with the following utility function over wealth: u(w) = ew, where e is the
exponential function (approximately equal to 2.7183) and w = wealth in hundreds of thousands of
dollars. Suppose that this person has a 40% chance of wealth of $50,000 and a 60% chance of wealth
of $1,000,000 as summarized by P(0.40, $50,000, $1,000,000)
a. What is the expected value of wealth?
b. Construct a graph of this utility function.
c. Is this person risk averse, risk neutral, or a risk seeker?
d. What is this person’s certainty equivalent for the prospect?
Ans:
9. An individual has the following utility func- tion: u(w) = w.5 where w = wealth.
a. Using expected utility, order the follow- ing prospects in terms of preference, from the most
to the least preferred:
P1(.8, 1,000, 600)
P2(.7, 1,200, 600)
P3(.5, 2,000, 300)
b. What is the certainty equivalent for prospect P2?
c. Without doing any calculations, would the certainty equivalent for prospect P1 be larger or
smaller? Why?
Ans:

a, công thức:
P1= .8*1000^.5+.2*.600^.5=30.197
P2=.7*1200^.5+.3*600^.5= 31.5972
P3=.5*2000^.5+.5*300^.5=31.0209
b,
u(w)=w^.5
u(CE)=31.5972
CE^0.5=31.5972
CE=31.5972^(1/.5)=998.3830
10. Consider two problems:
Problem 1: Choose between Prospect A and Prospect B.
Prospect A: $2,500 with probability .33,
$2,400 with probability .66,
Zero with probability .01.
Prospect B: $2,400 with certainty.
Problem 2: Choose between Prospect C and Prospect D.
Prospect C: $2,500 with probability .33,
Zero with probability .67.
Prospect D: $2,400 with probability .34,
Zero with probability .66.
It has been shown by Daniel Kahneman and Amos Tversky (1979, “Prospect theory: An analysis of
decision under risk,” Econometrica 47(2), 263–291) that more people choose B when presented with
Problem 1, and more people choose C when presented with Problem 2. These choices violate
expected utility theory. Why?
Ans:
This pattern of preferences violates expected utility theory in the manner originally described by Allais.
According to that theory, with u (0) = 0, the first preference implies u(2,400)> .33u(2,500) + .66u(2,400)
or .34u(2,400)> .33u(2,500) while the second preference implies the reverse inequality. Note that Problem 2
is obtained from Problem 1 by eliminating a .66 chance of winning 2400 from both prospects. under
consideration. Evidently, this change produces a greater reduc- tion in desirability when it alters the character
of the prospect from a sure gain to a probable one, than when both the original and the reduced
prospects are uncertain.