1 risk attitude dr. yan liu department of biomedical, industrial & human factors engineering...
TRANSCRIPT
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Risk Attitude
Dr. Yan LiuDepartment of Biomedical, Industrial & Human Factors Engineering
Wright State University
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Introduction
This example illustrates that EMV analysis does not capture risk attitudes of decision makers. Individuals who are afraid of risk or are sensitive to risk are called risk-averse.
Which game would you choose, game 1 or game
2?
Game 1
(0.5) (0.5)
Payoff
$30-$1
(0.5) (0.5)
$2,000-$1,900
Game 2
EMV=$14.5
EMV=$50
If EMV is the basis for the decision, you should choose Game 2. Most of us, however, may consider Game 2 to be too risky and thus choose Game 1.
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Utility Function
Utility functions are models of an individual’s attitude toward risk Utility functions translate dollars into utility units
Graph Table Mathematical expression
xxxx )(U),log()(U
Utility
Dollarsx
U(x)A utility function that displays risk-aversion
(upward sloping and concave)
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Risk Attitude Risk-Averse: Afraid or Sensitive to Risk
Would trade a gamble for a sure amount that is less than the expected value of the gamble
U(x) is a concave curve
xxx )(U )U(Δ)U()Δ(U xxxx (continuous) (discrete)
xxx )U( (continuous) (discrete
))(ΔU)(U)Δ(U xxxx
Risk-Seeking: Willing to Accept More Risk Would play a state lottery U(x) is a convex curve
Risk-Neutral: An EMV Decision Maker Maximizing utility is the same as maximizing EMV U(x) is a straight line
xx
)U(
(discrete))U(Δ)U()Δ(U xxxx is constant (continuous)
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Risk Attitude (Cont.)
Dollars
Utility
Risk-Averse
Risk-Neutral
Risk-Seeking
Shapes of Utility Functions of Three Different Risk Attitudes
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Some Terminologies
Expected Utility (EU) Weighted average of utilities of all possible states
Certainty equivalent (CE) Amount of money equivalent to the situation that involves uncertainty
Risk Premium Difference between the EMV and the CE, i.e., the amount you would pay to
avoid the risk
You have a lottery which has 0.3 probability of winning $200 and 0.7 probability of losing $10, and you are willing to sell it for $30.
The risk premium of the lottery is: (0.3*200+0.7*(-10))-30 =53-30=$23
Your certainty equivalent for this lottery is $30
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Certainty Equivalent
(CE)
EMV
Risk Premium
Utility Curve
Expected Utility (EU)
Utility
Dollar
U(CE) = EU
For a risk-seeking person, CE would be on the right side of EMV on the horizontal axis
Graphical Representation of Expected Utility, Certainty Equivalent, and Risk Premium
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Utility Assessment
Assessing a Utility Function is a Subjective Judgment Different people have different risk attitudes toward risk and are willing to
accept different levels of risk
Two Methods Assessment using certainty equivalent Assessment using probabilities
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Utility Function Assessment Via Certainty Equivalence
Assess several certainty equivalents from which the utility function is derived Step 1: set the utility of the best payoff to 1 and the utility of the worst payoff
to 0 Step 2: Construct a situation that involves uncertainty and find its CE using
reference lottery. Step 3: Calculate the expected utility of the lottery, EU. Because EU is equal
to U(CE), we get another point (CE, EU) on the utility curve Step 3: Repeat Steps 2 and 3 until getting enough points to plot the utility
curve
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You face an uncertain situation in which you may earn $10 in the worst case, $100 in the best case, or some amount in between. You have a variety of options, each of which leads to some uncertain payoff between $10 and $100. To evaluate the alternatives, you must assess your utility for payoffs from $10 to $100.
Step 1: let U(10)=0 and U(100)=1
Step 2: imagine you have the opportunity to play the following reference lottery
Suppose your CE in this lottery is $30
Step 3: Calculate EU of lottery A, which is 0.5∙U(100)+0.5∙U(10)=0.5. Therefore, U(30)=0.5 and you have found a third point on your utility curve.
Step 4: To find another point, you can take a different reference lottery, say using $100 and $30 as two equally likely outcomes in lottery A, and then follow steps 2 and 3. Continue with the same procedures until you have enough points to plot the utility function.
A (0.5)
(0.5)$100$10
B CE
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Suppose you now have five points on your utility curves: U(10)=0, U(18)=0.25, U(30)=0.5, U(50)=0.75, and U(100)=1, you can plot the utility function
x (Dollars)
U(x)
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Utility Function Assessment Via Probability-Equivalent
Assess the utility of a selected dollar amount directly Adjust the probability in the reference lottery
C (p)
(1-p)$100
$10
D $65
U(65) = p∙U(100) + (1-p)∙U(10) = p∙1+(1-p)∙0 = p
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Gambles, Lotteries, and Investments
Framing utility assessment in terms of gambles or lotteries may evoke images of carnival games or gambling which seem irrelevant to decision making or even distasteful
An alternative is to think in terms of risky investment, particularly for investment decisions Whether you should make a particular investment
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Risk Tolerance and Exponential Utility Function
Exponential Utility Function
Rx
ex
1)(UR is risk tolerance, showing how risk-adverse the function is. Larger R means less risk-adversion and makes the utility function flatter
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
0 1 2 3 4 5 6 7 8 10 11 12 12 14 15
R=1
R=3
R=5
Exponential Utility Functions with Three Different Risk Tolerances
x ↑ => U(x) →1x =0 => U(x) = 0
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Risk Tolerance and Exponential Utility Function (Cont.)
Assess Risk Tolerance R
The largest Y for which you prefer to take gamble E is approximately equal to your risk tolerance
Suppose you decide Y is $900, then R=900, and your utility function is 900/1)(U xex
E
(0.5)
(0.5)
$Y
– $Y/2F $0
Find CE of Given Uncertain Event First calculate the expected utility (EU) of the uncertain event Since U(CE)=EU, you can solve the equation to get CE
If you estimate the expected value, ,and variance, , of the payoffs, then CE can be approximately calculated as
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Risk Tolerance and Exponential Utility Function (Cont.)
2
R
25.0CE
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Suppose you face the following gamble: 1) win $2000 with probability 0.4; 2) win $1000 with probability 0.4, or 3) win $500 with probability 0.2, and your utility can be modeled as an exponential function with R=900. What is your CE of this gamble?
The expected utility of the gamble is: EU = 0.4∙U($2000)+0.4 ∙U($1000)+ 0.2∙U($500)= 0.4∙(1-e-2000/900) +0.4 ∙(1-e-1000/900)+ 0.2∙(1-e1-500/900) = 0.710
Solve 0.710=1-e-CE/900 for CE, you can get CE=$1114.71
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Constant and Decreasing Risk-Aversion
Constant Risk-Aversion The risk premium for a gamble does not depend on the initial wealth held, Can be represented using an exponential utility function
You have $x in your pocket, and you are facing a bet: 1) win $15 with probability 0.5, or 2) lose $15 with probability 0.5. Suppose your utility function can be modeled as an exponential function with risk tolerance R=35.
(0.5)
(0.5)$x+15
$x –15
$ in Pocket
Probability Tree of the Bet
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$x EV ($) CE ($) Risk Premium ($)
25 25 21.88 3.12
35 35 31.88 3.12
45 45 41.88 3.12
55 55 51.88 3.12
When x=$25EU=0.5∙U($10)+0.5∙U($40)=0.5∙(1-e-10/35)+0.5∙(1-e-40/35)=0.4648EU=U(CE) 0.4648=1-e-CE/35CE=$21.88EMV= 0.5∙10+0.5∙40=$25Risk Premium=EMV-CE=25-21.88=$3.12
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Constant and Decreasing Risk-Aversion (Cont.)
Decreasing Risk-Aversion Typically, people’s attitude towards risk changes with their initial wealth The risk premium for a gamble decreases along with the increase of wealth held Can be represented with the logarithmic utility function
)ln()(U xx
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$x EV ($) CE ($) Risk Premium ($)
25 25 20 5.00
35 35 31.62 3.38
45 45 42.43 2.57
55 55 52.92 2.08
When x=$25EU=0.5∙U($10)+0.5∙U($40)=0.5∙ln(10)+0.5∙ln(40)=2.9957EU=U(CE) 2.9957=ln(CE)CE=$20EMV= 0.5∙10+0.5∙40=$25Risk Premium=EMV-CE=25-20=$5
In the previous example of betting, suppose your utility function can be modeled as a logarithmic function
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Some Caveats
Utilities DO NOT Add Up U(A+B)≠U(A)+U(B) (why?)
Utility Difference Does Not Express Strength of Preferences U(A1)-U(A2) > U(B1)-U(B2) does not mean we would rather go from A1 to A2
instead of from B1 to B2
Utility only provides a numerical scale for ordering preferences, not a measure of their strengths
Utilities are Not Comparable from Person to Person A utility function is a subjective personal statement of an individual’s
preference
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Exercise
An investor with assets of $10,000 has an opportunity to invest $5,000 in a venture that is equally likely to pay either $15,000 or nothing. The investor’s utility function can be described by the log utility function U(x) =ln(x), where x is the total wealth.
a.What should the investor do?
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Invest
$10,000
success (0.5)
10,000-5,000= $5,000
Don’t
Invest
10,000-5,000+15,000 =$20,000Failure
(0.5)
Total Wealth
- $5,000
$15,000
a.
EU(invest) = 0.5∙U($20,000)+0.5∙U($5,000)=0.5∙ln($20,000)+0.5∙ln($5000) = 9.21EU(Don’t invest) = U($10,000) = ln($10,000) = 9.21Therefore, the investor is indifferent between the two alternatives
b. Suppose the investor places a bet with a friend before making the investment decision. The bet is for $1,000; if a fair coin lands heads up, the investor wins $1,000, but if it lands tails up, the investor pays $1,000 to his friend. Only after the bet has been resolved will the investor decide whether or not to invest in the venture. If he wins the bet, should he invest? What if he loses the bet? Should he toss the coin in the first place?
Invest
Success (0.5)
10,000+1,000-5,000= $6,000
Don’t Bet
10,000+1,000-5,000+15,000 =$21,000
Failure (0.5)
Total Wealth
-$1,000
$15,000
Bet
Win (0.5)
Lose (0.5)
$1,000
-$5,000
Don’t
Invest
10,000+1,000 = $11,000
Invest 10,000-1,000-
5,000= $4,000
10,000-1,000-5,000+15,000 =$19,000
$15,000-$5,000
Don’t
Invest
10,000-1,000 = $9,000
Invest 10,000-5,000=
$5,000
10,000-5,000+15,000 =$20,000
$15,000
-$5,000
Don’t
Invest
$10,000
Success (0.5)Failure (0.5)
Success (0.5)Failure (0.5)
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b.
EU(Invest|Win) = 9.326
EU(Don’t Invest|Win) = 9.306
EU(Invest|Lose) = 9.073
EU(Don’t Invest|Lose) = 9.105
EU(Bet) = 9.216
EU(Don’t Bet) = 9.21
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If he wins the bet:
EU(Invest) = 0.5∙ln($21,000) + 0.5∙ln($6,000) = 9.326EU(Don’t Invest) = ln($11,000) = 9.306
Therefore, if he wins the bet, he should invest the venture
If he loses the bet:
EU(Invest) = 0.5∙ln($19,000) + 0.5∙ln($4,000) = 9.073EU(Don’t Invest) = ln($9,000) = 9.105
Therefore, if he losses the bet, he should not invest the venture
EU(Bet) = 0.5∙EU(Invest|win) + 0.5∙EU(Don’t Invest |lose) = 0.5(9.326)+0.5(9.105) = 9.216EU(Don’t Bet) = 9.21 (from part a)
Therefore, he should bet