Utility Theory Investors maximize Expected Utility U = f(W) U(W) W Risk Averse Investor.

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Presentation transcript:

Utility Theory Investors maximize Expected Utility U = f(W) U(W) W Risk Averse Investor

Utility Theory (Cont’d) U(W) W W Risk Taker Risk Neutral

Utility Theory (Cont’d) Assume the following Utility function: U(w) = 2w w 2 where w represents change in Wealth. ProbStock A Stock B E(UA) = 19x x x0.30 = E(UB) = 64x x x0.30 = Choose A

Mean-Variance Criterion (1) Investors are risk averse (2) Returns are distributed normally, or investor Utility functions are quadratic An investor will prefer A to B if E(R A ) > E(R B ) and  A   B or E(R A )  E(R B ) and  A <  B

Return and Risk of a Portfolio Expected return of a portfolio: Variance of a portfolio:

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