CHAPTER 8
Risk Attitudes
Overview of Chapter 8
In this lecture, we will cover:
▪ Risk attitudes
▪ Introduce utility theory and expected utility for
risky decision making
Risk and Expected Monetary Value
▪ We have learned how to base decisions on
expected monetary values (EMVs).
▪ While the Expected Monetary Value
(EMV) approach is a useful and objective
decision-making tool(Convenient and objective)
but it has a limitation: it ignores individual risk
preferences (doesn’t consider individual
preferences and risk attitudes.)
Risk and Expected Monetary Value
▪ EMV assumes decision-makers are risk-neutral,
meaning they only care about the average outcome
and are indifferent to variability (risk).
▪ In reality, people can be risk-averse (prefer certainty
with higher EMV) or risk-seeking (prefer risky
options with higher payoffs)
Example
Game
Game
EMV is a great starting point, but for personal or high-stakes decisions, incorporating risk
preferences ( utility theory) leads to better choices.
Utility theory is a way of accounting for a decision maker's risk tolerance.
Risk Attitudes
▪ Risk-averse (concave curve) decision maker.
• Doesn’t like to lose—overestimates value of losing
▪ Risk-seeking (convex curve) decision maker
• Eager to enter
• Overestimates value of winning
▪ Risk-neutral (linear) decision maker
• Ignores risk
• Maximizing EMV
Risk Attitudes
Risk Attitudes
The three types of risk attitude utility functions:
Convex
Concave
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Expected Utility
▪ Expected Utility is the weighted average utility of all possible
outcomes, where weights are their probabilities.
▪ Expected Utility (EU) is a fundamental concept in economics and
decision theory that extends Expected Monetary Value (EMV) by
incorporating an individual's risk preferences and subjective valuation
of outcomes. Unlike EMV, which only considers the average
monetary payoff, EU accounts for how people feel about risk and
uncertainty.
Example Risk Attitudes
For example, how would you decide on which strategy
to take?
Strategy 1:
Win $30 with probability 0.5 Strategy 1
Lose $1 with probability 0.5
Strategy 2:
Win $2,000 with probability 0.5
Lose $1,900 with probability 0.5
Strategy 2
Example Risk Attitudes
Strategy 1
Strategy 2
Strategy 2 Strategy 1
Strategy 2
Example Risk Attitudes
Strategy 1
Example Risk Attitudes
Strategy 2
Strategy 1
Example Risk Attitudes
Strategy 1 Strategy 2
104.8M
Strategy 2
Example Risk Attitudes
Strategy 1 Strategy 2
Strategy 2
Strategy 1
Strategy 2
Strategy 1
Strategy 2
Strategy 1
Stock Market Example
The investor has funds that he wishes to invest. He has three choices:
▪ High-risk stock
▪ Low-risk stock
▪ Savings account that would pay $500
If he invests in the stocks, he must pay a $200 brokerage fee.
▪ If the market goes up, he will earn $1,700 from the high-risk stock and $1,200 from
the low risk stock.
▪ If the market stays at the same level, his payoffs for the high- and low-risk stocks
will be $300 and $400, respectively.
▪ If the stock market goes down, he will lose $800 with the high-risk stock but still
earn $100 from the low-risk stock.
The probabilities that the market will go up, stay the same, or go down are 0.5, 0.3, and
0.2, respectively.
What’s the best choice based on EMV? EU?
Stock Market Example
1. Expected Monetary Value (EMV) Analysis
High-Risk Stock:
EMV_high = (0.5 × (1700-200)) + (0.3 × (300-200)) + (0.2 × (-800-200))
= (0.5 × 1500) + (0.3 × 100) + (0.2 × -1000)
= 750 + 30 - 200 = $580
Low-Risk Stock:
EMV_low = (0.5 × (1200-200)) + (0.3 × (400-200)) + (0.2 × (100-200))
= (0.5 × 1000) + (0.3 × 200) + (0.2 × -100)
= 500 + 60 - 20 = $540
Stock Market Example
EMV Ranking:
1.High-Risk Stock ($580)
2.Low-Risk Stock ($540)
3.Savings account ($500)
Stock Market Example
2. Expected Utility Analysis (Using log utility U(W) = ln(W), W₀=$10,000)
High-Risk Stock:
EU_high = 0.5×ln(10000+1500) + 0.3×ln(10000+100) + 0.2×ln(10000-1000)
= 0.5×9.490 + 0.3×9.210 + 0.2×9.105
= 4.745 + 2.763 + 1.821 ≈ 9.329
Low-Risk Stock:
EU_low = 0.5×ln(10000+1000) + 0.3×ln(10000+200) + 0.2×ln(10000-100)
= 0.5×9.210 + 0.3×9.213 + 0.2×9.210
= 4.605 + 2.764 + 1.842 ≈ 9.211
Savings account:
EU_none = ln(10000) ≈ 9.210
Stock Market Example
4.745
2.763
9.329 1.821
4.605
savings account (9.210)
2.764
9.211 1.842
9.210
9.210
Expected Utility, Certainty Equivalents, and Risk Premiums
▪ Certainty equivalent (CE): The Certainty Equivalent (CE) is a
guaranteed amount of money that an individual would consider
equally desirable as a risky or uncertain investment. It represents the
minimum certain payoff an investor would accept in lieu of taking a
risk for a potentially higher, but uncertain, return.
▪ Risk Preference Dependent:
• A risk-averse person has a CE lower than the expected value.
• A risk-seeking person has a CE higher than the expected value.
• A risk-neutral person has a CE equal to the expected value.
Expected Utility, Certainty Equivalents, and Risk Premiums
3. Certainty Equivalents
▪ High-Risk Stock:
CE_high = e^9.329 - 10000 ≈ $11240 - $10000 =
$1,240
▪ Low-Risk Stock:
CE_low = e^9.211 - 10000 ≈ $10000 - $10000 = $0
Expected Utility, Certainty Equivalents, and Risk Premiums
▪ Risk premium: Risk Premium is the additional
expected return that an investor demands for
choosing a risky investment over a risk-free
alternative. It compensates investors for bearing
uncertainty and potential losses.
Risk Premium = EMV – CE
EMV = Risk Premium + CE
Expected Utility, Certainty Equivalents, and Risk Premiums
Expected Utility, Certainty Equivalents, and Risk Premiums
4. Risk Premiums
▪ High-Risk Stock:
RP_high = EMV_high - CE_high = 580 - 1240 = -$660
▪ Low-Risk Stock:
RP_low = EMV_low - CE_low = 540 - 0 = $540
Expected Utility, Certainty Equivalents, and Risk Premiums
Metric High-Risk Stock Low-Risk Stock Don't Invest
EMV $580 $540 $0
EU (ln) 9.329 9.211 9.210
CE $1,240 $0 $0
Risk Premium -$660 $540 -
1.EMV Recommendation: High-risk stock (580>580>540)
2.EU Recommendation: High-risk stock (9.329 > 9.211)
3.Risk Premium shows the high-risk stock is actually preferred (negative premium)
Expected Utility, Certainty Equivalents, and Risk Premiums
For example, the EMV in the stock investment case is
$580. If you would sell the opportunity for $250, then
that is your CE. What is your risk premium, that is,
how much would you give up to avoid the risk of
investing in the stock market?
Risk Premium = $580 – $250
Risk Premium = $330
Example
Basic situation:
Step 1b: Calculate EU
Step 1a: Find utility
values for payoffs
using the utility
function graph. Go
from x-axis to y-axis
Example
Step 2: Find CE for EU (from
Step 1) using same graph. Go
from y-axis to x-axis
Step 3: Calculate EMV
Step 4: Calculate Risk Premium
