Some important intuitions from yesterday Finance 4335 class meeting…
The most important concept covered in class yesterday is that people vary in terms of their preferences for bearing risk. Although we focused most of our attention on modeling risk-averse behavior, we also briefly considered examples of risk neutrality (where you only care about expected wealth and are indifferent about the riskiness of wealth) and risk loving (where you prefer to bear risk and are willing to pay money for the opportunity to do so).
Related to point 1: irrespective of whether you are risk averse, risk neutral, or risk loving, the foundation for decision-making under conditions of risk and uncertainty is expected utility. Given a choice among various risky alternatives, one selects the choice that has the highest utility ranking.
If you are risk averse, then and the difference between and is equal to the risk premium . Some practical implications — if you are risk averse, then you are okay with buying “expensive” insurance at a price that exceeds the expected value of payment provided by the insurer, since (other things equal) you’d prefer to transfer risk to someone else if it’s not too expensive to do so. On the other hand, you are not willing to pay more than the certainty equivalent for a bet on a sporting event or a game of chance.
If you are risk neutral, then and ; risk is inconsequential and all you care about is maximizing the expected value of wealth.
If you are risk loving, then and ; you are quite willing to pay for the opportunity to (on average) lose money.