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Utility functions
Ramana Sonti
BITS Pilani, Hyderabad Campus
Term II, 2014-15
1/12
Ramana Sonti
Preliminaries
Utility functions
Agenda
1 Preliminaries
Introduction
2 The risk-return tradeoff
Example
Indifference curves
3 Utility functions
Quadratic utility
Example revisited
2/12
Ramana Sonti
Preliminaries
Utility functions
Introduction
Investments
Households (people like you and me), earn income. Typically, there
Why invest?
because we want to trade consumption inter-temporally (across
periods)
in the absence of investment alternatives, we would simply store
3/12
Ramana Sonti
Preliminaries
Utility functions
Introduction
Consumption tomorrow
110
17% rate of return
100
Consumption today
Not seen in the above figure: the risk and return of the investments
4/12
Ramana Sonti
Preliminaries
Utility functions
Introduction
Consumption tomorrow
110
17% rate of return
100
Consumption today
Not seen in the above figure: the risk and return of the investments
4/12
Ramana Sonti
Preliminaries
Utility functions
Example
period
Choice 2: A risky investment which will grow to 150,000 with a
Return comparison
The risk-free rate here is rf =
105,000
100,000
1 = 5%
1 = 50% and
80,000
100,000
1 = 20% respectively
Ramana Sonti
Preliminaries
Utility functions
Example
period
Choice 2: A risky investment which will grow to 150,000 with a
Return comparison
The risk-free rate here is rf =
105,000
100,000
1 = 5%
1 = 50% and
80,000
100,000
1 = 20% respectively
Ramana Sonti
Preliminaries
Utility functions
Example
Comparison
Choice 2 has an expected return which is 17% more than the risk-free rate
Choice 2 also has a standard deviation of 34.29%
How can we tell if the 17% extra expected return is commensurate with the 34.29%
risk?
Ramana Sonti
Preliminaries
Utility functions
Example
Comparison
Choice 2 has an expected return which is 17% more than the risk-free rate
Choice 2 also has a standard deviation of 34.29%
How can we tell if the 17% extra expected return is commensurate with the 34.29%
risk?
Ramana Sonti
Preliminaries
Utility functions
Example
Comparison
Choice 2 has an expected return which is 17% more than the risk-free rate
Choice 2 also has a standard deviation of 34.29%
How can we tell if the 17% extra expected return is commensurate with the 34.29%
risk?
Ramana Sonti
Preliminaries
Utility functions
Example
Investor behavior
Basic assumptions
Assumption 1: Investors like more returns with less risk, i.e., we are
greedy
Assumption 2: Investors are risk averse
Ramana Sonti
Preliminaries
Utility functions
Indifference curves
Beer
8
6
4
2
0
0
Pizza
8/12
Ramana Sonti
Preliminaries
Utility functions
Indifference curves
U2
U1
Increasing
utility
Observations
9/12
Assumption 2 (risk aversion) means that at lower levels of risk, it takes a small amount of return to
induce the investor to take a given amount of risk. Since risk averse investors want to be
increasingly compensated with increasing risk, the curve is steeper as you climb
Ramana Sonti
Preliminaries
Utility functions
Indifference curves
U2
U1
Increasing
utility
Observations
9/12
Assumption 2 (risk aversion) means that at lower levels of risk, it takes a small amount of return to
induce the investor to take a given amount of risk. Since risk averse investors want to be
increasingly compensated with increasing risk, the curve is steeper as you climb
Ramana Sonti
Preliminaries
Utility functions
Indifference curves
E(r)
19%
More risk-averse
investors have
steeper
indifference curves
E(r)
Less risk-averse
investors have
flatter indifference
curves
14%
12%
15% 20%
10/12
(r)
15% 20%
(r)
Ramana Sonti
Preliminaries
Utility functions
Quadratic utility
1
U(E(r), (r)) = E(r) A 2 (r)
2
11/12
Ramana Sonti
Preliminaries
Utility functions
Example revisited
Clearly, for this investor, the risk-free asset is the better choice
Verify that for A = 2.0, the risky asset is the better choice
In practice, choices are not binary, of course we have the ability to
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Ramana Sonti