I received an email from a Finance 4335 student earlier today asking for further clarification of the two methods for calculating risk premiums which we covered in class last Thursday. Under the so-called “exact” method, one 1) calculates expected utility, 2) sets expected utility equal to the utility of the certainty-equivalent of wealth, 3) solves for the certainty-equivalent of wealth, and 4) obtains the risk premium by calculating the difference between expected wealth and the certainty-equivalent of wealth. On the other hand, the Arrow-Pratt method is an alternative method for calculating the risk premium which is based upon Taylor series approximations of expected utility of wealth and the utility of the certainty equivalent of wealth (the derivation for which appears on pp. 16-18 of http://fin4335.garven.com/fall2018/lecture6.pdf). Both of these approaches for calculating risk premiums are perfectly acceptable for purposes of Finance 4335.
The value added of Arrow-Pratt is that it analytically demonstrates how risk premiums depend upon two factors: 1) the magnitude of the risk itself (as indicated by variance), and 2) the degree to which the decision-maker is risk averse. For example, we showed in class on Thursday that the Arrow-Pratt coefficient for the logarithmic investor (for whom U(W) = ln W) is twice as large as the Arrow-Pratt coefficient for the square root investor (for whom U(W) = W.5); 1/W for the logarithmic investor compared with .5/W for the square root investor. Thus, the logarithmic investor behaves in a more risk averse than the square root investor; other things equal, the logarithmic investor will prefer to allocate less of her wealth to risky assets and buy more insurance than the square root investor. Another important insight yielded by Arrow-Pratt (at least for the utility functions considered so far in Finance 4335) is the notion of decreasing absolute risk aversion (DARA). Other things equal, an investor with DARA preferences become less (more) risk averse as wealth increases (decreases). Furthermore, such an investor increases (reduces) the dollar amount that she is willing to put at risk as she becomes wealthier (poorer).