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Preference Toward Risk, Risk Premium, Indifference Curves, and Reducing Risk

This document discusses concepts related to risk preferences, risk premium, indifference curves, and risk reduction through diversification. It begins by defining risk averse, risk neutral, and risk seeking preferences and provides utility function examples of each. It then discusses the risk premium and how to calculate it using indifference curves. Next, it shows how to plot indifference curves between expected value and standard deviation using job choice examples. Finally, it discusses how diversification across unrelated activities can reduce risk through examples of selling air conditioners and heaters or investing in a mutual fund versus a single stock.

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Luke Agbe
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38 views7 pages

Preference Toward Risk, Risk Premium, Indifference Curves, and Reducing Risk

This document discusses concepts related to risk preferences, risk premium, indifference curves, and risk reduction through diversification. It begins by defining risk averse, risk neutral, and risk seeking preferences and provides utility function examples of each. It then discusses the risk premium and how to calculate it using indifference curves. Next, it shows how to plot indifference curves between expected value and standard deviation using job choice examples. Finally, it discusses how diversification across unrelated activities can reduce risk through examples of selling air conditioners and heaters or investing in a mutual fund versus a single stock.

Uploaded by

Luke Agbe
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
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1 Preference Toward Risk

14.01 Principles of Microeconomics, Fall 2007

Chia-Hui Chen

September 26, 2007

Lecture 9

Preference Toward Risk, Risk Premium,

Indierence Curves, and Reducing Risk

Outline
1. Chap 5: Preference Toward Risk
2. Chap 5: Risk Premium
3. Chap 5: Indierence Curve
4. Chap 5: Reducing Risk: Diversication

Preference Toward Risk - Risk Averse / Neu


tral / Seeking (Loving)

Three dierent kinds of behaviors:

Risk Averse (Figure 1)


Facing two payos with the same expected value, prefer the less risky one.
Diminishing marginal utility of income.
Relation between the utility of expected value and expected utility
u(E(x)) > E(u(x)).
Example.
u(x) = ln x.

Risk Neutral (Figure 2)


Facing two payos with the same expected value, feel indierent.
Linear marginal utility of income.
Relation between the utility of expected value and expected utility
u(E(x)) = E(u(x)).
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

2 Risk Premium

2.5

u(x)

1.5

0.5

5
x

10

Figure 1: The Utility Function of Risk Averse.


Example.
u(x) = x.

Risk Seeking (Figure 3)


Facing two payos with the same expected value, prefer the riskier one.
Increasing marginal utility of income.
Relation between the utility of expected value and expected utility
u(E(x)) < E(u(x)).
Example.
u(x) = x2 .

Risk Premium

Risk premium. The maximum amount of money that a risk-averse person


would pay to avoid taking a risk.
Example (Job Choice). Assume that a risk-averse person whose utility function
corresponds with the curve in Figure 4 has two possible incomes.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

2 Risk Premium

u(x)

5
x

10

Figure 2: The Utility Function of Risk Neutral.

70

60

50

u(x)

40

30

20

10

5
x

10

Figure 3: The Utility Function of Risk Seeking.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

3 Indierence Curve between Expected Value and Standard


Deviation

20

18

16

14

u(x)

12

10

10

15

20

25

30

Figure 4: Risk Premium: A Utility Function.


His income I might be 10 with probability 0.5 and 30 with probability 0.5.
Then the expected value of income I is:
E(1) = 10 0.5 + 30 0.5 = 20,
with an expected utility:
E(u(I)) = u(10) 0.5 + u(30) 0.5 = 10 0.5 + 18 0.5 = 14.
If we oer him a xed income I , I = 16, then his expected utility is:
E(u(I )) = u(16) 1 = 14 1 = 14.
One can see that
E(u(I)) = E(u(I )).
However, E(I) E(I ) = 4. This means the person is willing to give up a value
of 4 in exchange for a riskless income. Thus, the risk premium is
Risk P remium = E(I) E(I ) = 20 16 = 4.

Indierence Curve between Expected Value


and Standard Deviation

The indierence curve we discussed before is about the quantities of two dierent
goods, now we consider the indierence curve about expected value and standard
deviation (Figure 5).

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

3 Indierence Curve between Expected Value and Standard


Deviation

1330

1320

1310

1300

Ex

1290

1280

1270

1260

1250

1240
400

500

600

700

800

900

1000

Figure 5: Indierence Curve between Expected Value and Standard Deviation.


Job 1
Job 2

Probability 0.5
900
625

Probability 0.5
1600
2025

Table 1: The Income and Probability of Two Jobs.

Example (Job choice). Suppose one has the following utility function

u(x) = x
and two job choices (see Table 1). Calculate expected utilities:

E(u(x1 )) = 0.5 900 + 0.5 1600 = 35,

E(u(x2 )) = 0.5 625 + 0.5 2025 = 35.

Thus, these two jobs give the person the same utility level, i.e. they are on a
same indierence curve.
In order to plot the indierence curve, we should calculate their expected
values and standard deviations.
E(x1 ) = 1250
(x1 ) = 494
E(x2 ) = 1325
(x2 ) = 990
Job 2 has higher expected value of income but it is riskier. (Figure 5)
Compare Figure 6 and Figure 7. The former is more risk averse since one
must compensate more for more risk.
Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

3 Indierence Curve between Expected Value and Standard


Deviation

90

80

70

60

Ex

50

40

30

20

10

10

Figure 6: Indierence Curve between Expected Value and Standard Deviation,


Larger Slope.

20

18

16

14

Ex

12

10

10

Figure 7: Indierence Curve between Expected Value and Standard Deviation,


Smaller Slope.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

4 Reducing Risk: Diversication

Reducing Risk: Diversication

Diversication. Reducing risk by allocating resources to dierent activities


whose outcomes are not closely related.
Example (Selling air conditioner and heater). Suppose that the weather
has a probability 0.5 to be hot and 0.5 to be cold. Table 2 shows the
companys prot if all its eorts in selling air conditioners (heaters) and
the weather turns out to be hot (cold).
Weather
Air Conditioner
Heater

Hot
30,000
12,000

Cold

12,000

30,000

Table 2: Diversication: Selling Air Conditioners and Heaters.

If one only sells air conditioners or heaters,


E(prof it) = 21, 000,
(prof it) = 9, 000.
If the company puts half of its eorts in selling air conditioners and
half of its eorts in selling heaters, then the prot is always 21,000
no matter the weather is cold or hot.
E(prof it) = 21, 000,
(prof it) = 0.
Thus we should choose to sell both to reduce risk.

Example (Example: Stock versus mutual fund). Mutual fund may have

the same return as stock but much less risk.

Example. Dont put all your eggs in one basket.

Cite as: Chia-Hui Chen, course materials for 14.01 Principles of Microeconomics, Fall 2007. MIT
OpenCourseWare (http://ocw.mit.edu), Massachusetts Institute of Technology. Downloaded on [DD Month
YYYY].

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