PORTFOLIO AND INVESTMENT NURIN HANIAH ASMUNI
ANALYSIS
CHAPTER 2: RATIONAL CHOICE THEORY
TOPIC 1: UTILITY FUNCTIONS
TOPIC 2 : INVESTMENT OPPORTUNITIES UNDER UTILITY FUNCTIONS
OBJECTIVE OF THIS CHAPTER: TOPIC 1
Explain how the following economic characteristics of investors can be
expressed mathematically in a utility function:
• Non-satiation
• Risk aversion, risk neutrality and risk seeking
• Declining or increasing absolute and relative risk aversion
Discuss the economic properties of commonly used utility functions
TOPIC 1: UTILITY FUNCTION
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TOPIC 1: UTILITY FUNCTION
2. Risk aversion
• Attitudes to risk can now be expressed in terms of the properties of utility functions.
• The form of utility function can model individual’s preferences whether he likes,
dislikes or indifferent to risk.
Risk-aversion investor
• A risk-averse investor values an incremental increase in wealth less highly than an
incremental decrease and will reject a fair gamble.
Fair gamble: the expected wealth of the individual unchanged. Also define as
gamble that has an overall expected value of zero
E.g.: toss unbiased coin once. If head; receive RM1. If tail; lose RM1.
the expected value: 0.5x(+1) + 0.5(-1) = 0 the gamble is fair
• Risk-averse investors utility on prospect of possible gain < (less) than prospect of
lose (with same probability of occurrence)
• However, they willing to accept additional risk from an investment if associated with
higher level of expected return feature of risk-return trade off
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TOPIC 1: UTILITY FUNCTION
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TOPIC 1: UTILITY FUNCTION
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TOPIC 1: UTILITY FUNCTION
Exercise 2.2.1
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TOPIC 1: UTILITY FUNCTION Certainty equivalent: guaranteed
return that an investor will accept
now than taking a chance of a
higher but uncertain return in the
future
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TOPIC 1: UTILITY FUNCTION
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TERMS
U(cw) = E[U(w+x)] : expected utility for certain equivalent of the combines
portfolio
cw = w+x : certainty equivalent of the combined portfolio of initial wealth plus
gamble
cx = cw – w : certainty equivalent of gamble only
W- wealth
X – gamble
U – expected utility
Cw, cx – wealth/amount
TOPIC 1: UTILITY FUNCTION
E(x)=0.5(1)+0.5(-1) = 0
U(cw)=E[U(w+x)] – expected
utility of certainty equivalent of
combined portfolio
Possible outcomes / probability:
+RM1 head : 0.5
-RM1 tail : 0.5
P1=0.5, Cw1= w+x = 10+1
P2=0.5, Cw2=w-x = 10 -1
Cx is negative. We would have to pay investor to accept the gamble.
Equivalently the investor would be prepared to pay 0.0251 to avoid
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the gamble 1-12
W = 100
Y +10%, -10%
W*y=110, 90
TOPIC 1: UTILITY FUNCTION W=1000
Y +10%, -10%
W*y=1100, 900
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TOPIC 1: UTILITY FUNCTION Absolute risk aversion: a
measure of investor reaction to
uncertainty relating to amount
change in their wealth
Cw increase, cx increase
Cw decrease, cx decrease
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TOPIC 1: UTILITY FUNCTION Relative risk aversion: a
measure of investor reaction to
gamble that proportional to
wealth
Example 3:
We shall see below that the log utility function U(w) = ln(w) exhibits:
• decreasing absolute risk aversion
• constant relative risk aversion.
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TOPIC 1: UTILITY FUNCTION
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TOPIC 1: UTILITY FUNCTION
Absolute risk aversion Relative risk aversion
Increasing A’(w)>0 R’(w)>0
Constant A’(w)=0 R’(w)=0
Decreasing A’(w)<0 R’(w)<0
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