L3: Risk and Risk Measurement 1 Risk and Risk Measurement (L3) Following topics are covered: –Risk –Defining “More Risk Averse” Utility functions Absolute risk aversion Relative risk aversion Risk premium Certainty equivalent –Defining “More Risky” Increase in risk Aversion to downside risk Stochastic dominance (Materials from Chapters 1&2 of EGS and Chapters 1&2 of HL)

L3: Risk and Risk Measurement 2 Risk Risk can be generally defined as “uncertainty”. Sempronius owns goods at home worth a total of 4000 ducats and in addition possesses 8000 decats worth of commodities in foreign countries from where they can only be transported by sea, with ½ chance that the ship will perish. If he puts all the foreign commodity in 1 ship, this wealth, represented by a lottery, is x ~ (4000, ½; 12000, ½) If he put the foreign commodity in 2 ships, assuming the ships follow independent but equally dangerous routes. Sempronius faces a more diversified lottery y ~ (4000, ¼; 8000, ½; 12000, ¼) In either case, Sempronius faces a risk on his wealth. What are the expected values of these two lotteries? In reality, most people prefer the latter. Why?

St. Petersburg Paradox You pay a fixed fee to enter and then a fair coin is tossed repeatedly until a tail appears, ending the game. The pot starts at 1 dollar is doubled every time a head appears. You win whatever is in the pot after the game ends. What is the fair price to pay for entering the game? Are you willing to pay this? See page 13, HL. L3: Risk and Risk Measurement 3

4 Risk Aversion and Utility Function A risk-averse agent is an agent who dislikes zero-mean risks. Risk aversion: –Utility function is the relationship between monetary outcome, x, and the degree of satisfaction, u(x). Concavity –a twice-differentiable function u is concave if and only if its second derivative is negative, i.e., if the marginal utility u’(x) is decreasing in x. –E.g, u(x)=ln(x) A decision maker is risk-averse  the agent’s utility function u is concave. – proposition 2, page 8, EGS –Be able to prove this Jensen Inequality

L3: Risk and Risk Measurement 5 Von Neumann_Morgenstern Utility Function von Neumann-Morgenstern utility describes a utility function (or perhaps a broader class of preference relations) that has the expected utility property: the agent is indifferent between receiving a given bundle or a gamble with the same expected value.

L3: Risk and Risk Measurement 6 Risk Premium and Certainty Equivalent Risk Premium –Risk-averse investors may want to purchase risky assets if their expected return exceed the risk-free rate. –Eu(w+z)=u(w-Π), where z is a zero-mean risk, w is the initial wealth –Π is risk premium – cost of risk Certainty equivalent –The amount of payoff (e.g. money or utility) that an agent would have to receive to be indifferent between that payoff and a given gamble –What is certainty equivalent in the above expression? Arrow-Pratt approximation of risk premium – where A(w)=-u’’(w)/u(w)

L3: Risk and Risk Measurement 7 Deriving Risk Premium (Arrow_Pratt Approximation) Note: The cost of risk, as measured by risk premium, is approximately proportional to the variance of its payoffs. This is one reason why researchers use a mean-variance decision criterion for modeling behavior under risk. However П=1/2σ 2 *A(w) only holds for small risk (thus we can apply for the 2 nd -order approximation).

L3: Risk and Risk Measurement 8 Further discussions Arrow-Pratt expression of risk premium works for small risk or special utility functions where only mean and variance are applicable to the expected utility –See page 20, quadratic utility function

L3: Risk and Risk Measurement 9 Measuring Risk Aversion The degree of absolute risk aversion For small risks, the risk premium increases with the size of the risk proportionately to the square of the size –Assuming z=k*ε, where E(ε)=0, σ(ε)=σ Accepting a small-mean risk has no effect on the wealth of risk-averse agents ARA is a measure of the degree of concavity of a utility function, i.e., the speed at which marginal utility decreases

L3: Risk and Risk Measurement 10 More Risk Averse Agent Consider two risk averse agents u and v. if v is more risk averse than u, this is equivalent to that A v >A u Conditions leading to more risk Aversion – page 14-15

L3: Risk and Risk Measurement 11 Example Two agents’ utility functions are u(w) and v(w).

L3: Risk and Risk Measurement 12 CARA and DARA CARA However, ARA typically decreases –Assuming for a square root utility function, what would be the risk premium of an individual having a wealth of dollar 101 versus a guy whose wealth is dollar with a lottery to gain or lose $100 with equal probability? What kind of utility function has a decreasing risk premium?

L3: Risk and Risk Measurement 13 Prudence Thus –u’ is a concave transformation of u. Defining risk aversion of (-u’) as –u’’’/u’’ This is known as prudence, P(w) The risk premium associated to any risk z is decreasing in wealth if and only if absolute risk aversion is decreasing or prudence is uniformly larger than absolute risk aversion P(w)≥A(w)

L3: Risk and Risk Measurement 14 Relative Risk Aversion Definition Using z for proportion risk, the relation between relative risk premium, П R (z), and absolute risk premium, П A (wz) is This can be used to establish a reasonable range of risk aversion: given that (1) investors have a lottery of a gain or loss of 20% with equal probability and (2) most people is willing to pay between 2% and 8% of their wealth (page 18, EGS). CRRA

L3: Risk and Risk Measurement 15 Some Classical Utility Function For more of utility functions commonly used, see HL, pages Also see HL, Page 11 for von Neumann-Morgenstern utility, i.e., utility function having expected value Appropriate expression of expected utility, see HL, page 6 and 7

L3: Risk and Risk Measurement 16 Measuring Risks So far, we discuss investors’ attitude on risk when risk is given –I.e., investors have different utility functions, how a give risk affects investors’ wealth Now we move to risk itself – how does a risk change? Definition: A wealth distributions w 1 is preferred to w 2, when Eu(w 1 )≥Eu(w 2 ) –Increasing risk in the sense of Rothschild and Stiglitz (1970) –An increase in downside risk (Menezes, Geiss and Tressler (1980)) –First-order stochastic dominance

L3: Risk and Risk Measurement 17 Adding Noise w 1 ~(4000, ½; 12000, ½) w 2 ~(4000, ½; ε, ½) [adding price risk; or an additional noise] Then look at the expected utility (page 29) General form: w 1 takes n possible value w 1, w 2,w 3,…, w n. Let p s denotes the probability that w 1 takes the value of w s. If w 2 = w 1 + ε  Eu(w 2 ) ≤ Eu(w 1 ).

L3: Risk and Risk Measurement 18 Mean Preserving Spread Transformation Definition: –Assuming all possible final wealth levels are in interval [a,b] and I is a subset of [a, b] –Let f i (w) denote the probability mass of w 2 (i=1, 2) at w. w 2 is a mean-preserving spread (MPS) of w 1 if 1.Ew 2 = Ew 1 2.There exists an interval I such that f 2 (w)≤ f 1 (w) for all w in I Example: the figure in the left-handed panel of page 31 Increasing noise and mean preserving spread (MPS) are equivalent

L3: Risk and Risk Measurement 19 Single Crossing Property Mean Preserving spread implies that (integration by parts – page 31) This implies a “single-crossing” property: F 2 must be larger than F 1 to the left of some threshold w and F 2 must be smaller than F 1 to its right. I.e.,

L3: Risk and Risk Measurement 20 The Integral Condition

L3: Risk and Risk Measurement 21 MPS Conditions Consider two random variable w 1 and w 2 with the same mean, (1)All risk averse agents prefer w 1 to w 2 for all concave function u (2)w 2 is obtained from w 1 by adding zero-mean noise to the possible outcome of w1 (3)w 2 is obtained w 1 by a sequence of mean-preserving spreads (4)S(w)≥0 holds for all w.

L3: Risk and Risk Measurement 22 Preference for Diversification Suppose Sempreonius has an initial wealth of w (in term of pounds of spicy). He ships 8000 pounds oversea. Also suppose the probability of a ship being sunk is ½. x takes 0 if the ship sinks and 1 otherwise. If putting spicy in 1 ship, his final wealth is w 2 =w+8000*x If he puts spicy in 2 ships, his final wealth is w 1 =w+8000(x 1 +x 2 )/2 Sempreonius would prefer two ships as long as his utility function is concave Diversification is a risk-reduction device in the sense of Rothschild of Stiglitz (1970).

L3: Risk and Risk Measurement 23 Variance and Preference Two risky assets, w 1 and w 2, w 1 is preferred to w 2 iff П2> П1 For a small risk, w 1 is preferred to w 2 iff the variance of w 2 exceeds the variance of w 1 But this does not hold for a large risk. The correct statement is that all risk-averse agents with a quadratic utility function prefer w 1 to w 2 iff the variance of the second is larger than the variance of the first –See page 35.

L3: Risk and Risk Measurement 24 Aversion to Downside Risk Definition: agents dislike transferring a zero-mean risk from a richer to a poor state. w 2 ~(4000, ½; ε, ½) w 3 ~(4000+ ε, ½; 12000, ½) Which is more risky Depends, generally agents dislike risks in lower states more. But it depends on agents’ utility function

L3: Risk and Risk Measurement 25 First-Degree Stochastic Dominance Definition: w 2 is dominated by w 1 in the sense of the first- degree stochastic dominance order if F 2 (w)≥F 1 (w) for all w. Consumers would dislike FSD-dominated shifts in the distribution final wealth No longer mean preserving F(w) w W2W2 W1W1

L3: Risk and Risk Measurement 26 Equivalent Conditions on FSD All agents with a nondecreasing utility function prefer w 1 to w 2 : Eu(w 2 )<=Eu(w 1 ) for all nondecreasing functions u, or stated as, W2 is dominated w1 in the sense of FSD: w2 is obtained from w1 by a transfer of probability mass from the high wealth states to lower wealth states, or F2(w)≥F1(w) for all w. W1 is obtained from w2 by adding nonnegative noise terms to the possible outcome of w2: where є is no less than 0 with probability one.

L3: Risk and Risk Measurement 27 Second-degree Stochastic Dominance Definition –w1 dominates w2 in the sense of the second-degree stochastic dominance if and only if –This is same mean preserving spread or adding a noise; see page 49, HL.

Allais Paradox The Allais paradox is a choice problem designed by Maurice Allais to show an inconsistency of actual observed choices with the predictions of expected utility theory.Maurice Allais Two pairs of games What is your choice? L3: Risk and Risk Measurement 28

Ellsberg Paradox (Ambiguity Aversion) The Ellsberg paradox is a paradox in decision theory and experimental economics in which people’s choices violate the expected utility hypothesis. It is generally taken to be evidence for ambiguity aversion. The 1urn paradox: suppose you have an urn containing 30 red balls and 60 other balls that are either black or yellow. You don't know how many black or yellow balls there are, but that the total number of black balls plus the total number of yellow equals 60. The balls are well mixed so that each individual ball is as likely to be drawn as any other. You are now given a choice: –Gamble A: You receive $100 if you draw a red ball –Gamble B: You receive $100 if you draw a black ball Also you are given options between Gamble C and D –You receive $100 if you draw a red or yellow ball –You receive $100 if you draw a black or yellow ball L3: Risk and Risk Measurement 29

L3: Risk and Risk Measurement 30 Technical Notes Taylor Series Expansion: f(x)= Integration by parts

L3: Risk and Risk Measurement 31 Exercises EGS, 1.2; 1.4; 2.2