Lecture 3 Flashcards
In a risky environment where investors have to have decisions, their future wealth is a?
Random variable
When utility numbers are assigned in a particular way, will the individual be more likely to choose the one that offers the highest or lowest expected utility?
Highest
What is the utility function?
A tool to describe the preferences of an individual, or a group of individuals
Doesn’t quantify the amount of utility received from consumption of the goods
Describes the ranking - is ORDINAL not cardinal
What does a risk averse graph look like?
Utility with a diminishing marginal utility of wealth.
Increasing curves (over)
\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_\_ way more curved tho
/
/
/ / /
What does a risk lover graph look like?
Utility with increasing marginal utility of wealth
Curve increasing but dipped
/ (way more curved)
/
/ —————/
What is a fair gamble?
One where the expected wealth is the same as the choice that’s available
Such a gamble has a pay off of zero
Will a risk averse accept a fair gamble?
No, never
Will a risk lover accept a fair gamble?
Yes, always
Comparability (axioms of rational choice)
For any pair of assets A and B
Investor can say; A>B; B>A or A=B
Transitivity (axioms of rational choice)
Preferences are transitive
If A>B, B>C then A>C
Independence (axioms of rational choice)
If A>B, then a gamble with outcomes containing A is preferred to the same gamble containing B
For any bet, there is a _______ which is equally preferred
Wealth certain
What is an indifference curve?
The locus of all assets (or combination os assets) between which we are indifferent
E(x^2)=
Var(x) + x̄^2
