Measuring Risk Aversion

Absolute Risk Aversion (refers to additive games):

Consider a risk averse investor.
If the absolute value of the certainty equivalent of a gamble decreases as the
investors wealth increases then the investor is said to exhibit declining absolute
risk aversion i.e. the more wealth the investor has the less he/she is prepared to
pay to avoid the risk of a gamble.
If the absolute value of the certainty equivalent of a gamble increases as the
investors wealth increases then the investor is said to exhibit increasing absolute
risk aversion ie the more wealth the investor has the more he/she is prepared to
pay to avoid the risk of a gamble.
Absolute Risk Aversion is measured by the function:
A(w) = -U(w)
U(w)

Relative Risk Aversion (refers to multiplicative games):

Consider a risk averse investor.
If the absolute value of the certainty equivalent of a gamble decreases/increases
as a proportion of total wealth, as wealth increases then the investor is said to
exhibit declining/increasing relative risk aversion i.e. the more wealth the
investor has the less/more he/she is prepared to pay as a proportion of total
wealth to avoid the risk of a gamble.
Relative Risk Aversion is measured by the function:
R(w) = -w U(w)
U(w)

A(w) & R(w) are know as the Arrow- Pratt measures.

Summary:
Suppose U(w)>0 & U(w)<0, then:
Increasing ARA I Cx l increases as a function of w ie A(w) >0
Decreasing ARA I Cx l decreases as a function of w ie A(w) <0
Increasing RRA I Cx l increases as a function of w ie R(w) >0
Decreasing RRA I Cx l decreases as a function of w ie R(w) <0
Constant ARA A(w) =0

Constant RRA R(w) =0

Investors who hold an increasing absolute amount of their wealth in risky assets,
as they get wealthier exhibit declining Absolute Risk Aversion.
Investors who hold an increasing proportion of their wealth in risky assets, as
they get wealthier exhibit declining Relative Risk Aversion.
Empirical evidence supports these 2 concepts.

6. Further comments on Utility Theory

Up to now we have been implicitly assuming that the same functional form of the
utility function models an investors preferences over all levels of wealth.
However it may not be appropriate to use a single form of a utility function to
carry out such modelling. One solution would be to use the same functional form
of the utility function but to vary the parameters applying to it over different
ranges of wealth
Eg. U(w) = wx,

with x = 0.75, 0<w<10,

x= .5 w>10.

However sometimes this approach may still not be sufficient to accurately model
how an investor will behave. Instead we may need to use a different functional
form of the utility function of an investor over different ranges of wealth an
approach know as using state dependent utility functions
Eg. U(w) = log w, w < 0.2
= w 0.5w2 , w >0.2
Here there is a discontinuous change in the investors behaviour at a level of
wealth of w=0.2 units. So as wealth goes above 0.2 this puts the investor in a
different state as regards his attitude to risk.
The wealth ranges, defining the change in functional form of the utility function
may relate to defined states or circumstances of the investor eg we may model
U(w) differently if the investor is in one of the states single, married or
divorced or we may model U(w) differently if we know the investor is about to
change from a solvent to insolvent position. Thus when the behaviour of the
investor is likely to be radically different depending on what state the investor is
in we model the persons behaviour via state-dependent utility functions.

Limitations of Utility Theory:

1. To make use of expected utility theory we need to know the precise shape
and level of the investors utility function/curve. We may not have such
information and it may be difficult to estimate accurately.
2. Expected utility theory cannot be applied separately to each of several
sets of risk choices facing the investor
3. For a large company (or more specifically for an entity comprising of a
collection of interest groups) it may not be possible to find a utility
function which reflects fully the company or entity as a whole.
4. The expected utility theory is not an efficient mechanism for modelling the
interdependence of sources of risk.