Module 3 - Utility Theory Flashcards
What is the utility function?
A tool to describe the preferences of an individual, or group of individuals.
It doesn’t quantify the amount of utility received from consumption of the goods.
It describes the ranking - it is ordinal and not cardinal.
Describe a risk adverse person.
Avoids risk.
Describe a risk loving person.
Enjoys taking on risk.
A utility with diminishing marginal utility of wealth describes what type of investor?
Risk adverse.
A utility with increasing marginal utility of wealth describes what type of investor?
Risk loving.
Define a fair gamble.
One where the expected wealth is the same as the choice that is available, and has an expected pay off of zero.
Who will accept a fair gamble?
A risk loving person. A risk adverse person will never accept a fair gamble because the utility associated with the payoffs in a risky situation increases less rapidly than the monetary value of these payoffs.
Describe comparability axiom.
For any pair of assets A & B, an investor can say A > B; B > A or A = B
Describe transitivity axiom.
Preferences are transitive; if A>B, B>C then A>C
Describe independence axiom.
If A>B, then a gamble with outcomes containing A is preferred to the same gamble containing B.
What is a way to represent preferences in risk-return spaces?
Using indifference curves.
Define indifference curves.
The locus (combination) of all assets between which we are indifferent.
If two assets lie on the same indifference curve, which would you pick?
We are indifferent, the expected utility from both are the same.
Say asset Z yields and expected utility of 20, and asset X and Y yield an expected utility of 18, which would you pick?
Asset Z. It yields a higher utility than both X and Y, and therefore lies on a higher utility curve.
