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Lecture

Expected Utility and Risk-Aversion

In course

FIN-609: Asset Pricing (2011 - 2024)

This course provides an overview of the theory of asset pricing and portfolio choice theory following historical developments in the field and putting emphasis on theoretical models that help our understanding of financial decision making and financial mar ...

Description

This lecture covers the historical development of expected utility theory, starting from Bernouilli's proposal to Von Neumann and Morgenstern's axiomatization. It discusses the concept of risk-aversion, Arrow Pratt measures of risk, and various utility functions. The lecture also explores the critique of expected utility theory, the concept of risk premium, and the implications of risk-aversion in decision-making under uncertainty.

Instructor

Semyon Malamud

Official source

Related concepts (32)

Risk aversion

In economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff.

Expected utility hypothesis

The expected utility hypothesis is a popular concept in economics that serves as a reference guide for decision making when the payoff is uncertain. The theory describes which options rational individuals should choose in a situation with uncertainty, based on their risk aversion. The expected utility hypothesis states an agent chooses between risky prospects by comparing expected utility values (i.e. the weighted sum of adding the respective utility values of payoffs multiplied by their probabilities).

Utility

As a topic of economics, utility is used to model worth or value. Its usage has evolved significantly over time. The term was introduced initially as a measure of pleasure or happiness as part of the theory of utilitarianism by moral philosophers such as Jeremy Bentham and John Stuart Mill. The term has been adapted and reapplied within neoclassical economics, which dominates modern economic theory, as a utility function that represents a consumer's ordinal preferences over a choice set, but is not necessarily comparable across consumers or possessing a cardinal interpretation.

Isoelastic utility

In economics, the isoelastic function for utility, also known as the isoelastic utility function, or power utility function, is used to express utility in terms of consumption or some other economic variable that a decision-maker is concerned with. The isoelastic utility function is a special case of hyperbolic absolute risk aversion and at the same time is the only class of utility functions with constant relative risk aversion, which is why it is also called the CRRA utility function.

Lecture

A lecture (from lēctūra ) is an oral presentation intended to present information or teach people about a particular subject, for example by a university or college teacher. Lectures are used to convey critical information, history, background, theories, and equations. A politician's speech, a minister's sermon, or even a business person's sales presentation may be similar in form to a lecture. Usually the lecturer will stand at the front of the room and recite information relevant to the lecture's content.

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Covers risk-neutral measure, state prices, utility functions, and risk aversion in asset pricing.

Expected Utility and Risk-Aversion: Theoretical Foundations

Explores expected utility, risk-aversion, insurance premiums, and portfolio choice in asset pricing.

Risk and Risk Premium

Explores risk evaluation, equivalent value, and insurance premium in lotteries, as well as discount rate adjustments.

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Explores risk aversion, utility functions, and asset pricing theory, including classic models and the Kreps-Porteus-Epstein-Zin utility function.

Related concepts (32)

Risk aversion

Expected utility hypothesis

Utility

Isoelastic utility

Lecture