Risk Preferences Flashcards
What is risk neutral?
She is indifferent to between two options with the same expected values; choosing the outcome with the highest expected return.
What is m-Principle?
Preference function depending on mean only, optimal alternatives can easily be identified, information is lost given that only one parameter (EV) is identified, the risk of the alternatives is not taken into account
What is risk averse?
She prefers to receive the expected value of a lottery for certain rather than owning the risky lottery; choosing the option with the highest expected return may not always be the best option because it ignores the riskiness.
What is (m,o) principle?
An individual’s preference function should take the mean AND the variance of the lottery into account, preference function depending on mean and variance/standard deviation of the random outcome. CHOOSE THE ALTERNATIVE THAT MAXIMIZES THE PREFERENCE FUNCTION!
What does risk aversion look with the (m,o) principle?
Indifference lines increase and become concave
What does risk neutral look like with the (m,o) principle?
Indifference lines are vertical.
What are two problems with the (m,o) principle?
1) Information might get lost if only mean & variance are considered.
2) Violation of state-by-state dominance
What is Bernoulli’s Principle–Utility of Consumption?
An individual’s decision rule is to choose the alternative that MAXIMIZES the EXPECTED UTILITY over all states of the world. Shape (curved growing to the right) implies liking more better than less and after having had more, the gain from the next extra unit decreases. EX: money, burgers
What are 4 fundamental preference assumptions?
1) completeness (the person can tell a preference
2) transitivity (the preference order is consistent
3) independence over lotteries (adding a risk does not matter)
4) continuity (preferences are continuous)
What are some of the shortcomings / limitations of the (m,o) principle?
1) The preference function may be hard to find
2) Info on the e.g. skewness of distribution may be lost
3) Decisions may violate state-by-state dominance
