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Econ 2100
Outline
1
Risk Aversion
Certainty Equivalent
Risk Premium
Fall 2015
y implies F (x)
F (y ) (nondecreasing);
Notation
F
x
=
x
x dF (x).
vdF
0
If F is dierentiable, the expectation
is
Z
Z computed using the density f = F :
v dF = v (x )f (x ) dx :
Betting
A Gamble
Suppose an individual is oered the following bet:
lose x with probability 1
win ax with probability p
p) ( x) = [pa + (1
p) ( 1)] x
Denition
A bet is actuarilly fair if it has expected value equal to zero (i.e. a = 1 p p ); it is
better than fair if the expected value is positive and worse than fair if it is negative.
How does she evaluate this bet? Use the expected utility model to nd out
If vNM index is v ( ) and initial wealth is w , expected utility is:
probability of winning
probability of losing
v (w + ax)
utility of wealh if win
(1
p)
v (w
x)
How much does she want of this bet? Answer by nding the optimal x.
p) v (w
x)
The FOC is
pav 0 (w + ax) = (1
rearranging
pa
(1
p)
p) v 0 (w
x)
v 0 (w x )
v 0 (w + x )
If the bet is fair, the left hand side is 1. Therefore, at an optimum, the right
hand side must also be 1.
If the vNM utility function is strictly increasing and strictly concave (v 0 > 0
and v 00 < 0), the only way a fair bet can satisfy this FOC is to solve
w + ax = w
which implies x = 0.
She will take no part of a fair bet.
What happens with a better than fair bet?
Insurance
An Insurance Problem
An individual faces a potential accident:
the loss is L with probability
Denition
An insurance contract establishes an initial premium P and then reimburses an
amount Z if and only if the loss occurs.
Denition
Insurance is actuarlly fair when its expected cost is zero; it is less than fair when its
expected cost is positive.
The expected cost of an insurance contract is
P
( Z ) + (1
loss
) (0)
no loss
=P
or
P +Z
wealth if loss
+ (1
)v
wealth if no loss
P)
}
v (W
L) + (1
{z
How much coverage will she want if she buys any coverage?
Find the optimal Z .
) v (W )
}
The answer depends on the premium set by the insurance company P as well
as the curvature of the utility function v .
Risk Aversion
Given some F , in our notation
value of F for sure.
Denitions
The preference relation % is
risk averse if, for all cumulative distribution functions F ,
F
% F:
F ).
Exercise
Let % be a preference relation on (R), the space of all cumulative distribution
functions, be represented by the following utility function:
x if F = x for some x 2 R
U(F ) =
0
otherwise
True of false: % is risk averse.
False: If
< 0, then F
F.
Certainty Equivalent
Denition
Given a strictly increasing and continuous vNM index v over wealth, the certainty
equivalent (CE) of F , denoted c(F ; v ), is dened by
Z
v (c(F ; v )) = v ( ) dF :
By denition, the certainty equivalent of F is the amount of wealth c( ) such
that that c( ) F .
DM is indierent between a distribution and the certainty equivalent of that
distribution.
The certainty equivalent is constructed to satises this indierence.
Risk Premium
Denition
Given a strictly increasing and continuous vNM index v over wealth, the risk
premium of F , denoted r (F ; v ) is dened by
r (F ; v ) =
c(F ; v ):
% is risk averse;
v is concave;
r (F ; v ) 0;
The proof uses Jensens inequality.
Jensens Inequality
Jensens inequality
A function g is concave if and only if
Z
g (x) dF
xdF
This says
g (E(X ))
E(g (X ))
dF
vdF
(1)
(3)
0
}
Proof.
% is risk averse, hence
% F for all F 2
R.
For any x; y 2 R and 2 [0; 1], let the discrete random variable X be such
that P(X = x) = and P(X = y ) = 1
. Let Fx ;y be the associated
cumulative distribution.
By risk aversion we have:
v(
v ( x + (1
F x ;y )
)y )
X
z
Thus v is concave.
v (z)dFx ;y (z)
v (z)P(X = z) = v (x) + (1
)v (y )
(1)
(3)
Proof.
Let v be concave, and X be a random variable with cdf F .
By Jensens inequality:
v (E(X ))
or
v(
F)
E(v (X ))
Thus
F
c(F ; v )
c(F ; v ) = r (F ; v )
0
}
(1)
(3) ) (1)
(3)
0
}
Proof.
Let r (F ; v )
Then we have
F
c(F ; v )
F)
% F for all F 2
v (c(F ; v )) =
v (x)dF (x)
We have shown that (1) ) (2) ) (3) ) (1), thus the proof is complete.
F %2
If DM1 prefers the lottery F to the sure payout x, then anyone who is less risk
averse than DM1 also prefers the lottery F to x .
Conversely, if DM2 prefers the sure payout x to the lottery F , then anyone who
is more risk averse than DM2 also prefers the sure payout x to the lottery F .
Again, this denition does not assume anything about preferences.
When both preferences satisfy expected utility, we have extra implications.
v1 =
c(F ; v1 )
r (F ; v1 )
r (F ; v2 ), for all F .
Proof.
Question 5 in Problem Set 8
: R ! R;
Econ 2100
Fall 2015
Problem Set 8
Due 26 October, Monday, at the beginning of class
1. Kreps 6.2
2. Kreps 6.7
3. An individual has expected utility preferences with utility over money given by some twice dierentiable function v with v 0 > 0 and v 00 < 0. She can choose the value of t in the following bet: receive
txs dollars with probability s with s = 1; :::; S (note that some of the xs are negative). Her initial
wealth is w for all s.
(a) Show that
S
P
s xs
s=1
(b) What (if anything) can you say about the optimal t when
S
P
s xs
s=1
S
P
s xs
< 0?
s=1
(c) Interpret these results in terms of better than fair gambles. What would happen if v 00 = 0?
(d) Can you say anything about how those answers will change as the decision maker in question
becomes more risk averse?
4. An individual whose wealth is W > 0 could have an accident in which she loses L with probability
. Let u denote the individual utility for money, and assume this function is dierentiable at least
twice with u0 > 0 and u00 < 0. An insurance policy species the premium the consumer has to pay
regardless of the accident (P ), and the amount the insurance company reimburses if the accident
occurs (Z). The latter is chosen by the consumer.
(a) Show that if insurance is actuarilly fair, the consumer will insure the entire loss.
(b) Characterize the relation between the optimal insurance coverage and the premium P . Interpret
this result. (hint: draw a picture)
(c) Can you say anything about how those answers will change as the decision maker in question
becomes more risk averse?
5. Suppose %1 and %2 are preference relations represented by the vNM indices v1 and v2 . Prove that
the following are equivalent:
(a) %1 is more risk averse than %2 ;
(b) v1 =
(c) c(F; v1 )
(d) r(F; v1 )
: R ! R;