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Risk Aversion and Stochastic Dominance

This document discusses concepts related to comparing distributions of returns according to risk and return levels. It defines first-order stochastic dominance, which means distribution F unambiguously yields higher returns than distribution G, and second-order stochastic dominance, which means distribution F is unambiguously less risky than distribution G. For first-order stochastic dominance, distribution F has higher values than distribution G for all values of x. For second-order stochastic dominance, any risk-averse utility function will prefer distribution F over G if they have the same mean, and G is considered a mean-preserving spread of F if and only if F demonstrates second-order stochastic dominance over G.

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Serdar Öztetik
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4 views2 pages

Risk Aversion and Stochastic Dominance

This document discusses concepts related to comparing distributions of returns according to risk and return levels. It defines first-order stochastic dominance, which means distribution F unambiguously yields higher returns than distribution G, and second-order stochastic dominance, which means distribution F is unambiguously less risky than distribution G. For first-order stochastic dominance, distribution F has higher values than distribution G for all values of x. For second-order stochastic dominance, any risk-averse utility function will prefer distribution F over G if they have the same mean, and G is considered a mean-preserving spread of F if and only if F demonstrates second-order stochastic dominance over G.

Uploaded by

Serdar Öztetik
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd

micro2 digital note 2

serdar oztetik
April 3, 2015

relative risk aversion cont.

1.1

non-increasing relative risk=aversion

individdual becomes less risk-averse with regard to gamblesthat are propotional


to hi wealth as his wealth increases. which is a stronger statement than absolute
one

comparison of payoff distributions in terms of


risk and return

two natural ways to compare distributions acording to the level of returns and
according to the dispersion of returns.
F() yields unambiguiously higher returns than G() ( 1st order stochastic
dominance)
F() is unambigiously less risky than G() (second order stochastic dominance

2.1

first-order stochstic dominance

F) FOSD G if for every nondecreasing func. u:RR we have


Z
Z
u(x)dF (x) u(x)dG(x)
propostion: F() FOSD G if and only if F (x) G(x) for all x
(there is a graph here)

2.2

second order stochastic dominance

risk aversion does not play a role in fosd but sosd it is important
here for the sake of simplicity we assume that the two disrtibutionss we
compare have identical means.
1

if F() sosd g then any risk-averse expected utility maximum prefers F over
G (ie F is less risky thanG)
definition: for any two disributions F(x) and G(x) with the same mean, F()
SOSD G if for every non-decreasing concave function R to R we have:
Z
Z
u(x)dF (x) u(x)dG(x)
note: G is a mean-preserving spread of F if and only if F SOSD G

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