1. Chapter 13
Risk Attitudes .

2. Chapter 13, Risk Attitudes
Learning Objectives:
Utility Function
Risk Premium
Utility Function Assessment
Exponential utility Function

3. Risk Attitudes
This chapter will discuss the problems associated with risk and return trade-off.
Study of preference for decision making
It is important for decision maker to consider their attitudes toward risk

4. Risk
Basic decision on expected monetary values (EMVs) is convenient, but it can lead to decision that may not seem intuitively appealing.
Using expected Values to make decision means that the decision maker is considering only the average payoff
EMV does not capture the risk attitudes.

5. Utility Function
The utility Function represents a way to translate dollars into “Utility Units”.
A utility function might be specified in terms of :
Graph
Tabular form
Mathematical expression.

6. Risk Attitude
Utility Function is only a model of an individual’s attitude toward risk.
Three different shapes for utility functions:
Risk-Seeking
Risk-Neutral
Risk-Avers

7. Risk Attitude
Risk neutrality is reflected by a utility curve that is simply a straight line.
For Risk Neutral person , maximizing EMV is the same as maximizing expected utility
A convex (opening upward) utility curve indicates risk-seeking behavior
A concave (opening downward) utility curve indicates risk-averse behavior

8. Risk Attitude
The purpose of a utility function is to help decision maker to choose from among alternatives that have uncertain payoffs.
Instead of maximizing expected value, the decision maker should maximize expected utility.

9. Risk Attitudes Expected Utility
Using Expected Utility to rank alternatives in order of preference
Two concepts are closely linked to the idea of expected utility:
Certainty Equivalent
Risk Premium

10. Risk Attitudes
Certainty Equivalent: the amount of money that is equivalent in your mind to given situation that involves uncertainty.
Ranking alternatives by their certainty equivalents is the same as ranking them by their expected utilities.

11. Risk Attitude
The notation of a Risk Premium can be thought of as a measure of how risk-averse a decision maker is in regard to a particular risky situation.
The risk premium is defined as the difference between the EMV and the certainty equivalent.
Risk Premium=EMV - Certainty Equivalent

12. Risk Attitudes
Certainty equivalent is a dollar amount, whereas expected utility is in utility units
A certainty equivalent is not the same as the expected utility
The two measurements translate through the utility function.

13. Utility Function Assessment
The basic procedure for assessing a utility function requires comparison of lotteries with riskless payoffs
Different people have different risk attitudes and thus are willing to accept different level of risk.
Assessing a utility function is a matter of subjective judgment, just like assessing subjective probability.

14. Utility Function Assessment
Two utility-Assessment approaches:
Assessment using Certainty Equivalents
Requires the decision maker to assess several certainty equivalents
Assessment using Probabilities
This approach use the probability-equivalent (PE) for assessment technique
Exponential Utility Function:
U(x) = 1-e-x/R
R is called risk tolerance

15. Risk Attitudes Summary
Basic concepts that underlie risk and return trade-offs
Basic procedure for assessing utility function
Certainty Equivalents and Risk Premium