Advanced Financial Theory

Measuring Risk and Risk Aversion

1 Introduction
Advanced Financial Theory Overview
• The objective of this course is to familiarise students with advanced concepts in decision making under uncertainty and
the relationship between risk based decisions and financial valuation.
• The module presents the standard results in risk based valuation and how they relate to the underpinning notions of risk
aversion and temporal (time) consistency.
• The module will look at state contingency and future outcomes and provide students with the tools needed to support
concepts taught across a range of topics across your degree.
• Most importantly, this module underpins the basic knowledge needed to understand how the financial system works, how
securities are valued and why some puzzles in finance, which might at first seem obvious, have complex underpinnings.

Portfolio
Analysis

Corporate
Econometrics
Finance

Advanced
Financial
Theory

Financial Risk
Derivatives
Management

Module Structure
1. Measuring Risk and Risk Aversion
2. Financial Risks and Optimality
3. Theory of Insurance
4. Static Portfolios
5. Linear Pricing
6. Consumption and Saving
7. Dynamic Portfolios
8. Risk and Information
9. Portfolio Optimisation
This is a table of common notation, it can be helpful to keep this separately to help you.

1
 Table 1: Common Notation

Symbol Meaning
w Wealth (initial or current wealth level)
x Payoff (outcome of a gamble, portfolio, or asset)
x̃ Random variable payoff (uncertain outcome)
p Probability of a particular outcome
{xi , pi } Discrete lottery: outcome xi with probability pi
F (x) Cumulative distribution function (CDF) of payoff
f (x) Probability density function (PDF) of payoff
E[ · ] Expectation operator (mean value)
E[x̃] Expected payoff
Var(x̃) Variance of the payoff (risk measure)

Table 2: Common Notation

Symbol Meaning
U (w) or u(w) Utility of wealth w
U ′ (w) or u′ (w) Marginal utility of wealth
U ′′ (w) or u′′ (w) Second derivative (concavity: U ′′ (w) < 0 for risk aversion)
E[U (x̃)] Expected utility of a random payoff
CE Certainty equivalent: certain payoff yielding same utility as a lottery
RP Risk premium: E[x̃] − CE
U ′′ (w)
A(w) = − ′ Arrow–Pratt measure of absolute risk aversion
U (w)
U ′′ (w)
R(w) = −w ′ Arrow–Pratt measure of relative risk aversion
U (w)

Learning Objectives on Measuring Risk Aversion

By the end of this lecture you should be able to do the following:
• Understand risk aversion.
• Understand how risk aversion is measured and how utility functions are defined.
• The concept of expected utility, certainty equivalence and risk premia.
• Understand absolute and relative risk aversion.
• Place these concepts in the wider context of valuation under uncertainty.

Introduction & Background

• Risk is an ever-prevalent challenge to both individuals and society. Likewise, an individual may react differently to
different consequences from the same risk.
- A person who decides she does not need to carry her umbrella with such a small risk of rain, may decide nonetheless
to stop by the parking lot on the way to the restaurant to put the top up on her new cabriolet automobile.

Hence: While the likelihood of an outcome may remain unchanged, decisions can and will most likely vary on the
size of a loss that might be incurred.

Measuring Risk
• Typically people behave as if they are averse to uncertain situations. Evidence for this comes from the large and
ubiquitous demand for insurance, and a burgeoning collection of experimental results and other results.
• To take into account uncertainty in the decision making, the Expected Utility framework is used.

2
Comparing Risks
Consider the following choices A and B
1. (A) Receive certain $0.10 or (B) $0.20 with a 50% probability or nothing with a 50%.
2. (A) Receive certain $1 or (B) $2 with a 50% probability or nothing with a 50%.
3. (A) Receive certain $10 or (B) $20 with a 50% probability or nothing with a 50%.
4. (A) Receive certain $100 or (B) $200 with a 50% probability or nothing with a 50%.
5. (A) Receive certain $1,000 or (B) $2,000 with a 50% probability or nothing with a 50%.
6. (A) Receive certain $10,000 or (B) $20,000 with a 50% probability or nothing with a 50%.
7. (A) Receive certain $100,000 or (B) $200,000 with a 50% probability or nothing with a 50%.
8. (A) Receive certain $1,000,000 or (B) $2,000,000 with a 50% probability or nothing with a 50%.
In each case the expected payoff is the same, but would you evaluate each lottery with the same perspective?

Understanding Risk Aversion

Definition:
• A decision-maker is risk averse if they prefer a certain payoff to a risky lottery with the same expected value.
• Equivalent: They have a concave utility function [we will come to this soon].

Intuition:
• Risk-averse individuals dislike variability in outcomes.
• They are willing to pay a premium to avoid risk.

Example:
• Lottery: 50% chance to win $100, 50% chance to win $0.
• Expected value = $50.
• A risk-averse person may prefer a guaranteed $45 instead.

An historical perspective on risk aversion

Financial Economists like historical perspectives on risk valuation: consider the following from ancient
Rome (although the term “ducat” as a measure of wealth is from medieval Europea):
• Sempronius owns goods at home worth a total of 4000 ducats and in addition possesses 8000 ducats worth of commodities
in foreign countries from where they can only be transported by sea. However, it is a dangerous time and our daily
experience teaches us that the probability a ship will sink is 50%.
• This wealth may be represented by a lottery ex , which takes on a value of 4000 ducats with probability 21 (if his ship is
sunk), or 12000 ducats with probability 12 . We will denote such a lottery ex as being distributed as (4000, 21 ; 12000, 12 ).
Its mathematical expectation is given by:

Expected Utility

1 1
E[ex ] ≡ × 4000 + × 12000 = 8000 ducats (1)
2 2

An historical perspective on risk aversion

Since common wisdom suggests that diversification is a good idea, so let us split the cargo on two ships, we would expect
that the value attached to ey exceeds that attributed to ex .
However, if we compute the expected profit, we obtain:
Expected Utility

1 1 1
E[ey ] = × 4000 + × 8000 + × 12000 = 8000 ducats (2)
4 2 4

This is the same value as for E[ex ].

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Concave Risk Aversion and Utility
A utility function connects measurable wealth to an abstract notion of well being.
It is normally denoted by u(w).
In financial economics we assume that individuals are ‘non-satiable’, hence more is always better, as such the utility is
always increasing, hence the first derivative, u′ (w), is always positive.
The concept of concavity means that the second derivative u′′ (w), is always negative.
An example of a function with these properties is the square root function, or:
√ 1
u(w) = w = w2

Example: A Concave Utility Function

√
u(w) = w
3
Utility u(w)

0
0 1 2 3 4 5 6 7 8 9 10
Wealth w

The structure of concavity

In practice simple risk aversion can be represented by any concave function of wealth...

3.5
√
u(w) = w
3 u(w) = ln(w)
u(w) = w0.3
2.5 u(w) = 1 − e−0.5w
Utility u(w)

1.5

0.5

0
0 1 2 3 4 5 6 7 8 9 10
Wealth w

By contrast if a utility function is convex, then the behaviour described by this function is risk seeking, that is an individual
would reject a certain outcome with the same expected payoff to a risky lottery.

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 30

Risk-seeking utility u(w) = w2

Risk-neutral u(w) = w
20

Utility u(w)

10

0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Wealth w

Sempronius’ problem
Whilst risk seeking behaviour can exist, it is not a commonly assumed property when dealing with meaningful financial
choices. Furthermore, the implications of risk aversion are quite profound.
√
In order to illustrate this point, let us consider a specific example of a utility function, such as u(x) = x. Using these
preferences in Sempronius’ problem, we can determine the expectation of u(x):
Expected Utility

1√ 1√
E[u(ex )] = 4000 + 12000 = 86.4 (3)
2 2

Expected Utility

1√ 1√ 1√
E[u(ey )] = 4000 + 8000 + 12000 = 87.9 (4)
4 2 4

Because lottery ey generates a larger expected utility than lottery ex , the former is preferred by Sempronius.

Decision Rules
Each probability unit transferred yields a reduction in expected utility equaling to u(12000) − u(8000). But the concavity
of u implies that:
Expected Utility

u(8000) − u(4000) > u(12000) − u(8000) (5)

i.e., that the positive effect of these combined mean-preserving transfers must dominate the negative effect. This is why all
investors with a concave utility would support Sempronius’ strategy to diversify risks.

Definition and characterization of risk aversion

In technical terms, this relationship is characterised by a utility function u contingent on individual preferences which, for
every wealth level w, conveys the level of utility u(w) attained with this wealth.

As such, u transforms the objective expected value of wealth w, say, from a lottery, into the subjective and preference
specific utility u(w).

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Definition and characterization of risk aversion
Final wealth comes from initial wealth w plus the outcome of any risk borne during the period. Observe that any lottery
z̃ with a non-zero expected payoff can be decomposed into its expected payoff E[z̃] and a zero-mean lottery z̃ − E[z̃].

Thus, from our definition, a risk-averse agent always prefers receiving the expected outcome of a lottery with certainty,
rather than the lottery itself. For an expected-utility maximizer with a utility function u, this implies that, for any lottery z̃
and for any initial wealth w.
Expected Utility Theory

E[u(w + z̃)] ⩽ u(w + E[z̃]) (6)

Definition and characterization of risk aversion

If we consider the simple example from Sempronius’ problem, with only one ship the initial wealth w equals 4000, and the
profit ze takes value 8000 or 0 with equal probabilities. Because our intuition is that Sempronius must be risk averse, it must
follow that:
Risk Aversion Example

1 1
u(12000) + u(4000) ≤ u(8000). (7)
2 2

If Sempronius could find an insurance company that would offer full insurance at an actuarially fair price of E[z] = 4000
ducats, Sempronius would be better off by purchasing the insurance policy.

Definition and characterization of risk aversion

Let us consider the following simple decision problem. An agent is offered a take-it-or-leave-it offer to accept lottery z̃ with
mean µ and variance σ 2 .

The optimal decision is to accept the lottery if:

Expected Utility Theory

E[u(w + z̃)] ⩾ u(w + E[z̃]) (8)

or, equivalently, if the certainty equivalent e of z̃ is positive. In the following, we examine how this decision is affected by
a change in the utility function.

Definition and characterization of risk aversion

Finally, if u is linear, then the welfare Eu is linear in the expected payoff of lotteries. Indeed, if

u(x) = a + bx for all x

then we have
Expected Utility Theory

E[u(w + z̃)] = E[a + b(w + z̃)] = a + b(w + E[z̃)] = u(w + E[z̃]) (9)

which implies that the decision maker ranks lotteries according to their expected outcome. The behavior of this individual
is called risk-neutral.

Definition and characterization of risk aversion

A decision maker with utility function u is risk-averse, i.e. inequality holds for all w and ez , if and only if u is concave.

Proof: The proof of sufficiency is based on a second-order Taylor expansion of u(w + z) around w + E[ez ]. For any z, this
yields:
Expected Utility Theory

u(w + z) = u(w + E[ez ]) + (z − E[ez ])u′ (w + E[ez ]) + 0.5(z − E[ez ])2 u′′ (ξ(z)) (10)

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Definition and characterization of risk aversion
for some ξ(z) in between z and E[ez ]. Because this must be true for all z, it follows that the expectation of u(w + ez ) is
equal to:

Expected Utility Theory

E[u(w + ez )] = u(w + E[ez ]) + u′ (w + E[ez ])E(ez − E[ez ]) + 0.5E[(ez − E[ez ])2 u′′ (ξ(ez ))] (11)

Definition and characterization of risk aversion

Now take a small zero-mean risk eε such that the support of final wealth w + eε is entirely contained in (w − δ, w + δ).
Using the same Taylor expansion as above yields:
Expected Utility Framework

E[u(w + eε )] = u(w) + 0.5E e2ε u′′ (ξ(eε ))

 
(12)

Because ξ(eε ) has a support that is contained in [w − δ, w + δ] where u is locally convex, u′′ (ξ(eε )) is positive for all
realizations of eε .

Consequently, it follows that E e2ε u′′ (ξ(eε )) is positive, and E[u(w+eε )] is larger than u(w). Thus, accepting the zero-mean
 
lottery eε raises welfare and the decision maker is not risk-averse. This is a contradiction.

Risk Premium and Certainty Equivalent

• The degree of risk aversion can be quantified by determining the Risk P remium Π which is an amount one is willing to
pay to get rid of the zero-mean risk z̃.

That is, Π is the cost of risk. For an agent with utility function u and initial wealth w, the risk premium must satisfy
the following condition:
Certainty Equivalent

E[u(w + z̃)] = u(w − Π) (13)

Risk Premium and Certainty Equivalent

• The agent ends up with the same welfare either by accepting the risk or by paying the risk premium Π. When risk z̃ has
an expectation that differs from zero, we usually use the concept of the certainty equivalent. The certainty equivalent e
of risk z̃ is the sure increase in wealth that has the same effect on welfare as having to bear risk z̃, i.e.,
Certainty Equivalent

E[u(w + z̃)] = u(w + e). (14)

• When z̃ has a zero mean, comparing equations implies that the certainty equivalent e of z̃ equals minus its its risk
premium Π.
Certainty Equivalent

e = Ez̃ − Π (15)

Risk Premium and Certainty Equivalent

• We can estimate the amount that the agent is ready to pay for the elimination of this zero-mean risk by considering
small risks. Assume that E z̃ = 0. Using a second-order and a first-order Taylor approximation for the left-hand side and
the right-hand side of equation respectively, we obtain that
Certainty Equivalent
u(w − Π) ≈ u(w) − Πu′ (w) (16)
E[u(w + z̃)] ≈ E u(w) + z̃u′ (w) + 0.5z̃ 2 u′′ (w)
 
(17)
′ ′′ 2
= u(w) + u (w)Ez̃ + 0.5u (w)Ez̃ (18)
= u(w) + 0.5σ 2 u′′ (w), (19)

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Risk Premium and Certainty Equivalent
The lottery outcome is characterized by E[z̃] = 0 and σ 2 = E[z̃ 2 ] which is the variance of the outcome of the lottery.

Replacing these two approximations yields the follwing:

Certainty Equivalent

1 2
π′ = σ A(w) (20)
2

Risk Premium and Certainty Equivalent

where the function A is defined as:
Absolute Risk Aversion

−u′′ (w)
A(w) = (21)
u′ (w)

Under risk aversion, function A is positive. It would be zero or negative respectively for a risk-neutral or risk-loving agent.
A(·) is hereafter referred to as the degree of absolute risk aversion of the agent.

Risk Premium and Certainty Equivalent

It measures the curvature of the utility function, and its derivative A′ (w) shows how individual preferences change in
response to changes in a unit of wealth:
• A′ (w) < 0 implies Decreasing Absolute Risk Aversion (DARA) that individuals will hold larger monetary amounts in
risky assets as they get wealthier as they become less risk averse,
• A′ (w) = 0 implies Constant Absolute Risk Aversion that an individual will hold the same amount in risky assets as they
get wealthier, and
• A′ (w) > 0 implies an Increasing Absolute Risk Aversion that an individual will hold smaller monetary amount in risky
assets when as they get wealthier.

3.5
Utility u(w)
u(w)
3

2.5 (E[w], u(E[w]))

(CE, u(CE))
2

1.5

0.5
Π = E[w] − CE
Wealth w
1 2 3 4 5 6 7 8 9 10

Decreasing Absolute Risk Aversion and Prudence

The risk premium Π = π(w) as a function of initial wealth w can be evaluated by solving the following equation:
Decreasing Absolute Risk Aversion

E[u(w + ez )] = u(w − π(w)) (22)

for all w. Fully differentiating (1.10) with respect to w yields:

8
Decreasing Absolute Risk Aversion

E[u′ (w + ez )] = (1 − π ′ (w))u′ (w − π) (23)

Decreasing Absolute Risk Aversion and Prudence

or, equivalently,
Decreasing Absolute Risk Aversion

u′ (w − π) − E[u′ (w + ez )]
π ′ (w) = (24)
u′ (w − π)

Thus, the risk premium is decreasing with wealth if and only if:
Decreasing Absolute Risk Aversion

E[v(w + ez )] ≤ v(w − π(w)) (25)

where function v ≡ −u′ is defined as minus the derivative of function u.

Decreasing Absolute Risk Aversion and Prudence

′′′
For this utility v, the measure of absolute risk aversion is Av = A − u′ = − uu′′ . This measure has several uses, which will be
′′′
made clearer later in this book. For this reason, without justifying the terminology at this stage, we will define P (w) = − uu′′ (w)
as the degree of absolute prudence of the agent with utility u. It follows from that −u′ is more concave than u if and only if:
Decreasing Absolute Risk Aversion

P (w) ≥ A(w) (26)

Decreasing Absolute Risk Aversion and Prudence

for all w. We conclude that condition P ≥ A uniformly is necessary and sufficient to guarantee that an increase in wealth
reduces risk premia. Because:
Decreasing Absolute Risk Aversion

A′ (w) = A(w) [A(w) − P (w)] (27)

condition P ≥ A is equivalent to the condition A′ ≤ 0. We obtain the following Proposition.

Decreasing Absolute Risk Aversion and Prudence

Intuitively, the same fixed risk is more trivial for wealthier people who are generally less willing to pay to eliminate it.
• The risk premium will be decreasing with wealth if P (w) ⩾ A(w) uniformly for all w, where P (w) is the degree of
absolute prudence of the agent with utility u and defined as −u′′′ (w)/u′′ (w).
• The condition (w) ⩾ A(w) is equivalent to A′ (w) ⩽ 0. That is, the risk premium of any risk z̃ is decreasing in wealth if
and only if Absolute Risk Aversion is decreasing (DARA) or if and only if prudence is uniformly larger than absolute
risk aversion. However, DARA requires that u′′′ (w) is positive for prudence to be positive.

Relative Risk Aversion

Relative Risk Aversion R(w) is a unit-free measurement of sensitivity and is defined as the rate at which marginal utility
changes when wealth is increased by one percent.
Degree of risk aversion

−wu′′ (w)
R(w) = = wA(w) (28)
u′ (w)

Π(wz̃)
Analogously, a unit-free relative risk premium for absolute risk can be expressed as Π̂(z̃) = w ⋍ 21 σ 2 R(w) to analyse
the share of wealth agents are willing to pay to insure against risk with a more risk-averse agent paying a higher risk premium
and to establish acceptable degrees of risk aversion.

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Example Relative Risk Aversion Formulation
As an example, let us take the following function
 1−γ
w −1
1−γ
, γ ̸= 1
u(w) =
ln(w), γ=1


What will be the form of the coefficient of relative risk aversion for this function?

Step 1: Compute derivatives for γ ̸= 1

d w1−γ − 1
u′ (w) = = w−γ , u′′ (w) = −γw−γ−1
dw 1 − γ

Step 2: Substitute into R(w):

w (−γw−γ−1 )
R(w) = − =γ
w−γ

Step 3: Interpretation: γ is constant; hence the CRRA utility function exhibits constant relative risk aversion.

Changing the γ parameter

5

γ = 0 (risk-neutral)
4 γ = 0.5
γ=1
γ=2
Utility U (w)

0
0 0.5 1 1.5 2 2.5 3 3.5 4 4.5 5
Wealth w

Relative Risk Aversion

However, there is no consensus on how R(w) changes as wealth changes due to the following two contradictory effects
• Under the intuitive DARA assumption, becoming wealthier means becoming less risk-averse reducing Risk Premium.
• Becoming wealthier, however, also means facing a larger absolute risk wz̃ raising Risk Premium.

Degree of risk aversion

Let us consider the following simple decision problem. An agent is offered a take-it-or-leave-it offer to accept lottery ez
with mean µ and variance σ 2 .
The optimal decision is to accept the lottery if:
Degree of risk aversion

E[u(w + ez )] ≥ u(w) (29)

or, equivalently, if the certainty equivalent e of ez is positive. In the following, we examine how this decision is affected by
a change in the utility function.

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Degree of risk aversion
This must be true independent of the common initial wealth level w of the two agents. If this definition were restricted to
small risks, we know from the above analysis that this would be equivalent to requiring that:
Degree of risk aversion

−v ′′ (w) −u′′ (w)

Av (w) = ′
≥ = Au (w) (30)
v (w) u′ (w)

for all w. If limited to small risks, v is more risk-averse than u if function Av is uniformly larger than Au . We say in this
case that v is more concave than u in the sense of Arrow-Pratt.

Degree of risk aversion

It is important to observe that this is equivalent to the condition that v is a concave transformation of u, i.e., that there
exists an increasing and concave function φ such that:

v(w) = φ(u(w)) (31)

for all w. Indeed, we have:

v ′ (w) = φ′ (u(w))u′ (w) (32)

and

v ′′ (w) = φ′′ (u(w))(u′ (w))2 + φ′ (u(w))u′′ (w) (33)

which implies that:

−φ′′ (u(w))u′ (w)
Av (w) = Au (w) + (34)
φ′ (u(w))
Thus, Av is uniformly larger than Au if and only if φ is concave.

The degree of risk aversion

Let us go back to the example of Sempronius’ single ship yielding outcome ez = (0, 12 ; 8000, 12 ), with an initial wealth
√
w0 = 4000 ducats. If Sempronius’ utility function is u(w) = w, his certainty equivalent of ez equals eu = 3464.1, since:
Relative Risk Aversion

1√ 1√ √
4000 + 12000 = 86.395 = 7464.1 (35)
2 2

Alternatively, suppose that Sempronius’ utility function is v(w) = ln(w), which is also increasing and concave. It is easy to
check that v is more concave than u in the sense of Arrow-Pratt.

Some standard results for utility functions

• Quadratic Utility Functions
Utility Functions

1 2
u(w) = aw − w , for a ⩾ w (36)
2
however a flaw of Quadratic Utility Functions is that they require u to be non-decreasing, only true if w is smaller than
a. It also exhibits unlikely increasing absolute risk aversion.

Some standard results for utility function

• Constant Absolute Risk Aversion (CARA) Utility Functions
Utility Functions

exp(−aw)
u(w) = − (37)
a
are exponential functions where a is some positive scalar. These functions exhibit CARA with A(w) = a for all w. When
u is exponential and w is normally distributed with mean µ and variance σ 2 , the Arrow-Pratt approximation is exact
and Π = 12 σ 2 A(w).

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Some standard results for utility functions
The distinguishing feature of these utility functions is that they exhibit constant absolute risk aversion, with A(w) = a for
all w. It can be shown that the Arrow-Pratt approximation is exact when u is exponential and ew is normally distributed with
mean µ and variance σ 2 . Indeed, we can take expectations to see that:
Utility Functions
(w − µ)2
Z  
1
E[u(ew )] = − √ exp(−aw) exp − dw (38)
σa 2π 2σ 2
(w − (µ − 0.5aσ 2 ))2
 Z   
1 1
= − exp(−a(µ − 0.5aσ 2 )) √ exp − dw (39)
a σ 2π 2σ 2
1
= − exp(−a(µ − 0.5aσ 2 )) = u(µ − 0.5aσ 2 ). (40)
a

Implications and Applications

The implications of the standard utility theory set-up are profound, with standard risk aversion assumptions we can make
mathematical statements on the valuations of risk premia and insurance contracts and choosing between investments.

The obvious application is insurance. We buy insurance specifically because we are risk averse and this will be a famous
result we will come back to later in the module.

However, most countries do now require investment advisors to understand the degree of risk aversion a client investor will
exhibit.

On the next slide is an example of a series of lotteries designed to elicit risk preferences, this is taken from: Risk Aversion
and Incentive Effects by Charles A. Holt and Susan K. Laury, 2002. American Economic Review, 92 (5): 1644-1655.

An example of a commercial risk profiler can be found here:

[Link]

Table 3: Comparable lotteries to elicit risk aversion (Holt–Laury style)

# p (High) Option A (safer) Option B (riskier) EV(A) EV(B)

1 0.1 High $2.00; Low $1.60 High $3.85; Low $0.10 1.64 0.48
2 0.2 High $2.00; Low $1.60 High $3.85; Low $0.10 1.68 0.85
3 0.3 High $2.00; Low $1.60 High $3.85; Low $0.10 1.72 1.23
4 0.4 High $2.00; Low $1.60 High $3.85; Low $0.10 1.76 1.60
5 0.5 High $2.00; Low $1.60 High $3.85; Low $0.10 1.80 1.98
6 0.6 High $2.00; Low $1.60 High $3.85; Low $0.10 1.84 2.35
7 0.7 High $2.00; Low $1.60 High $3.85; Low $0.10 1.88 2.73
8 0.8 High $2.00; Low $1.60 High $3.85; Low $0.10 1.92 3.10
9 0.9 High $2.00; Low $1.60 High $3.85; Low $0.10 1.96 3.48
10 1.0 High $2.00; Low $1.60 High $3.85; Low $0.10 2.00 3.85

In each row, participants choose between Option A and B. p is the probability of the high payoff; the low payoff occurs with
probability 1 − p.

A risk-neutral chooser would switch from A to B when p ≈ 0.45 (between rows 4 and 5). Later switching indicates risk aversion;
earlier switching indicates risk seeking.

Summary
In this lecture we have looked at the following concepts:
• Understanding risky choices and uncertain outcomes.
• The concept of risk aversion.
• How risk aversion is characterised in a mathematical framework.
• Some common results on risk aversion:
– Concavity and Expected Utility
– Risk premia and certainty equivalence
– Constant Relative Risk Aversion
– Absolute Risk Aversion

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