BU275 Lecture Notes - Lecture 5: Risk Neutral, Utility, Downside Risk
Document Summary
Making decisions based solely on expected value is problematic: reason: the marginal utility of money often decreases, the pain of a loss outweighs the pleasure of an equal gain. Payoffs are translated to utilities using utility functions: u(v)=u maps payoff v to a utility value u, this function may be expressed as a table or as a mathematical formula, for example: A utility function is a property of the decision maker. Creating a utility table (more complex: utility function should always be increasing in payoff. Give the decision maker the choice between the guaranteed payoff amount or a lottery where they receive the highest payoff with probability p and the lowest payoff with probability (1-p). This p is the utility of that payoff, in utiles . i. e. u(v)=p. Estimating utility according to your risk preference. Give the decision maker the choice of the certain amount, or the lottery.
