3 Introduction to Assessing Risk

Important Question. How do we assess the risk an investor faces when choosing among assets?
In this discussion we examine how an investor would assess the risk associated with investments.
This assessment is carried out in terms of how an individual is aected by taking on additional risk.
In Figure 1 we plot the monthly returns on stocks (left graph) and short term government
bonds (right graph) from 1926 2008. The smooth line is a standard normal distribution with
a standard deviation which matches the data for stock and bond returns, respectively. The stock
return is the value of the weighted average of all stocks traded in the United States. The arithmetic
(geometric) average return on stocks is 0.94% (0.80%) or 11.28% (9.6%) per year. The ination
rate over this same period was 0.25% per month or 3.0% per year. As a result, the return on stocks
adjusted for ination was 8.28% per year. The short-term government rate is the 3-month Treasury
bill rate. The average short term rate is 0.3% (3.6% per year) per month or a rate of return after
adjusting for ination of 0.25% per month, the real return on short-term government bonds over
this period was 0.6% per year. As a result, the real return on stocks was greater than the return
on short term bonds by 7.68% per year. Given such an advantage to holding stocks why do people
hold short term bonds?
30 20 10 0 10 20 30
0
0.02
0.04
0.06
0.08
0.1
% Returns
D
e
n
s
i
t
y
Monthly Stock Returns (19262008)


Geometric Mean = 0.8%
Arithmetic Mean = 0.94%
0.8 0.6 0.4 0.2 0 0.2 0.4 0.6 0.8 1 1.2
0
0.5
1
1.5
2
2.5
3
% Return
D
e
n
s
i
t
y
Monthly Risk Free Returns (19262008)


Geomteric Mean = 0.3%
Arithmetic Mean = 0.3%
Figure 1: Monthly Returns on Stocks and Bonds.
In this lecture we will show that the excess return on stocks stems from the fact that stocks
are riskier assets than bonds, and so investors must be paid an additional amount known as a risk
premium to compensate for the added uncertainty and volatility. One way to see the risk is to look
at the distribution of monthly returns on stocks and the short term interest rate. In particular, the
range of the short term rate was [0.1, 1.2]% per month, while the uctuation in stock returns was
[25, 25]% per month. In fact there are several months in which the investor would lose over 10%
of stock value such as in October and November 2008. As a result, we refer to the rate on short
term bonds as the risk-free rate. We will show in the rest of the lecture that investors demand a
higher return on stocks to compensate for the risk of losing part of their wealth when they invest
in stocks.
41
4 Utility Functions
To measure how an individual feels we introduce a utility function which has two properties that
are common to all individuals:
1. An individual feels better if she has more goods.
2. An individuals utility increases at a decreasing rate as she obtains more goods.
The rst condition means that consumers gain util-
ity as they acquire more things, so that the utility
function has a positive rst derivative at every point
for which the utility function is dened. The second
condition is a little more subtle, but is analogous to
the principle of diminishing returns in economics. If
you are a poor person, then giving you more goods
increases your utility a lot. However, a rich person,
like Bill Gates, would have a smaller increase in util-
ity when given a similar increase in goods, since his
consumption is already quite high. This second con-
dition means that the utility function has a negative
second derivative at every point for which the utility
function is dened. These properties are represented
by the general form of the individuals utility func-
tion in Figure 2.
Denition 1: A utility function u = u(C) is a corre-
spondence which assigns to each consumption choice
C a real number u(C) (indicating the satisfaction
from the consumption C) such that:
u

(C) > 0 and u

(C) < 0. (4.1)

Consumption
C
U
t
i
l
i
t
y
u
Utility
0
Figure 2: General Utility Function.
5 Risk Premiums and Actuarially Fair Gambles
We now examine how an individual responds to the uncertainty associated with investment in the
stock market. First we consider the concept of a fair gamble to represent uncertainty.
Denition 2: An actuarially fair gamble is a random variable z with a positive payo z
1
with
probability p and a negative payo z
2
with probability 1 p. In addition, the expected value is
zero, E(z) = pz
1
+ (1 p)z
2
= 0, while the variance is Var(z) = pz
2
1
+ (1 p)z
2
2
. The standard
deviation is =

V ar(z).
Example 1: Suppose you have to pay $5,000 for a bet in which you win $10,000 with p =
1
2
, and
you get $0 with 1 p =
1
2
. As a result, z
1
= 10, 000 5, 000 = 5, 000 and z
2
= 0 5, 000 = 5, 000.
Note here that payos have the initial payment for the bet deducted. In this case, the expected
gain is
E(z) =
1
2
(5, 000) +
1
2
(5, 000) = 0.
The variance is
V ar(z) =
1
2
5, 000
2
+
1
2
5, 000
2
= 25, 000, 000.
42
As a result, the standard deviation is
=

25, 000, 000 = 5, 000.

Exercise 1. Suppose the probability of a positive payo is p = 0.9 in Example 1. If the positive
payo stays at z
1
= 5, 000, what is the new value of the negative payo z
2
so that the random
variable is an actuarially fair gamble.
Denition 3: An investor is strictly risk averse if she will not accept an actuarially fair gamble.
Denition 4: The risk premium is implicitly
dened as the amount an investor is willing to
pay to avoid an actuarially fair gamble. The risk
premium is implicitly dened such that
u(C ) = pu(C +z
1
) +(1 p)u(C +z
2
), (5.2)
where C is the consumption without the gamble.
The right hand side is the expected utility of the
investor from the actuarially fair gamble, that is,
the expected value of the utility function. On the
other hand, the left-hand side is the utility from
the sure payment of C . We can rewrite this
equation in probabilistic terms, recalling Deni-
tion 2, we can write:
E[u(C +z)] = u(C )
The calculation of the risk premium is illustrated
in Figure 3.
C
u
0 C+z
2
A
C+z
1
pu(C+z
1
) +(1-p)u(C+z
2
)
u(C+z
2
)
u(C+z
1
)
B
C
u(C- )
C-
Figure 3: Risk Premium
Example 2: Suppose an investor has a logarithmic utility function
u(C) = ln(C).
What is the risk premium under the actuarially fair gamble of Example 1?
Solution: Substituting the data from Example 1 into the implicit denition of risk premium from
equation(5.2), we now have
ln(C ) = p ln(C +z
1
) + (1 p) ln(C +z
2
),
so that
= C (C +z
1
)
p
(C +z
2
)
1p
Suppose we use the actuarially fair gamble in example 1 with initial consumption C = 50, 000. The
risk premium becomes
= 50000 (55000)
0.5
(45000)
0.5
= 250.63.
This means that this investor would pay $250.63 to avoid the actuarially fair gamble with standard
deviation of $5, 000.
Exercise 2. Given the actuarially fair gamble in exercise 1, nd the risk premium for the investor
in example 2. Why do you think the risk premium changed?
43
6 Relating Stocks and Bonds to an Actuarially Fair Gamble
We can relate an actuarially fair gamble to the uncertainty in stocks relative to investing in risk
free bonds. Remember that the payo from investing in either stocks or bonds are given by the
decision trees in Figure 4.
p
1-p
S
1
(H)= uS
0
S
1
(T)= dS
0
S
0
1+r
B
0
= $1
p
1-p
1+r
Figure 4: Payos from Stocks and Bonds.
Given these payos from stocks and bonds we can compare the utility of the investor when she
buys bonds and stocks. If she purchases bonds, then her utility is certain, and is measured at the
point B in Figure 5. Her utility at this point is u
B
= u[(1 +r)X
0
] where X
0
is the amount invested.
If she uses all her wealth to buy stocks, such that S
0
= X
0
, then her utility is uncertain. Before the
random event occurs, her expected utility from buying stocks is
E
s
[u(X
0
)] = pu(uX
0
) + (1 p)u(dX
0
).
(Warning: The symbol u inside the utility function u stand for up value of the stock.) In order
for the trade-o between stocks and bonds to be an actuarially fair gamble, we require that, under
the conditions described above,
E
s
[u(X
0
)] = u[(1 +r)X
0
], (6.3)
so that the expected utilities of the value of the investors wealth when investing in the stock and
the value of the wealth after accruing interest for one period are the same. This is demonstrated
in Example 3 below. In Figure 5, we take p =
1
2
so the expected utility is given by the point S.
Thus, the investor is expected to lose utility when the stock is an actuarially fair gamble. We show
in subsequent lectures that this leads to a higher expected return on stocks to convince risk averse
investors to hold the stock.
C
u
0 C=(1+r)X
0
C
d
= dX
0
C
u
= uX
0
S
B
u
d
u
u
u
B
u
S
Bonds
Stocks
44
Figure 5: All stocks versus all bonds.
Example 3: Suppose that the the price of the stock at the end of the rst period (year) is:
S
1
(H) = 100 and S
1
(T) = 25. Also let the risk free interest rate be r = 0.05 and the probability of
the good state p = 0.5. Suppose the investors wealth is X
0
= 59.52. After one year the investors
wealth is 62.50. If S
0
= 59.52, then the stock price is a fair gamble. To see this calculate the
expected stock price
pS
1
(H) + (1 p)S
1
(T) = 0.5 100 + 0.5 25 = 62.5.
The proceeds from the bond is
(1 +r)X
0
= (1.05) 59.52 = 62.5.
As a result, the investor ends up with $62.50 on average if she invests in either the stock or the bond.
However, the expected utility from the stock as illustrated in Figure 5 is less than the expected
utility from investing in the risk free bond. Thus, for any investor to buy stock at time t = 0
its price must be less than 59.52 giving the investor a reward for taking risk.
Exercise 3. Suppose the probability of the good state is 0.9, what should the stock price be for
the stock to be an actuarially fair gamble relative to the risk-free bond? Let the individual investor
have logarithmic preferences. What does the stock price have to be so that the investor receives
the same utility from the stock and bond?
7 Measuring the Risk Premium
We now show how to relate the risk premium to the shape of the utility function following the
argument by Kenneth Arrow, the 1972 winner of the Nobel Prize in Economics.
Theorem 7.1 A risk averse investor with utility function u(C) and consumption C

has a risk
premium which is approximated by

1
2
Var(z)
u

(C

)
u

(C

)
> 0
for an actuarially fair gamble.
Proof: To start, we can dene the risk premium at the specic consumption C

according to
Denition 4, i.e.,
u(C

) = pu(C

+z
1
) + (1 p)u(C

+z
2
). (7.4)
The proof applies a rst order Taylor approximation to the left hand side of this denition near
the point C

. Second, we take a second order Taylor approximation of the right hand side near the
point C

. We then equate these two results and solve for the unknown risk premium . Recall that
the notation T
(n)
(x
0
, x) refers to the n-th Taylor polynomial of x estimated at the point x
0
, which
has known values.
Take a rst order Taylors polynomial expansion of the left hand side of (7.4) near the point C

to nd
u(C

) T
(1)
(C

, C

) = u(C

) +u

(C

)((C

) C

),
45
so that
u(C

) u(C

) u

(C

). (7.5)
Next, nd the second order Taylors polynomial expansion of the right hand side of (7.4) near
the point C

to obtain
pu(C

+z
1
) + (1 p)u(C

+z
2
) T
(2)
(C

, C

+z
1
) +T
(2)
(C

, C

+z
2
)
= p

u(C

) +u

(C

)z
1
+
1
2
u

(C

)z
2
1

+
(1 p)

u(C

) +u

(C

)z
2
+
1
2
u

(C

)z
2
2

= u(C

) +u

(C

) [pz
1
+ (1 p)z
2
] +
1
2
u

(C

pz
2
1
+ (1 p)z
2
2

.
Note that in the rst step above we took the Taylor expansion of only the parts of the formula
containing z
1
and z
2
resepectively. Now recognize that the random variable is an actuarially fair
gamble so that
E(z) = pz
1
+ (1 p)z
2
= 0 and V ar(z) = pz
2
1
+ (1 p)z
2
2
.
As a result the approximation of the right hand side of (7.4) is
pu(C

+z
1
) + (1 p)u(C

+z
2
) u(C

) +
1
2
u

(C

)V ar(z). (7.6)
Thus, the approximation of (7.4) is given by comparing (7.5) with (7.6)
u(C

) u

(C

) u(C

) +
1
2
u

(C

)V ar(z).
The nal step is to solve for the risk premium

1
2
Var(z)
u

(C

)
u

(C

)
.
Lastly, note that by the denition of the utility function, we have u

(C

) < 0 and u

(C

) > 0, so
the formula implies that

1
2
Var(z)
u

(C

)
u

(C

)
> 0.
This completes the proof. Exercise 5 asks you to employ an argument similar to the one used
in this proof to nd more precise approximations of the risk premium using higher order Taylor
polynomials.
Example 4: Redo Example 2 using the Arrow measure of the risk premium.
Solution: From Example 1 the variance is 25, 000, 000. The derivatives of the logarithmic utility
function are
d ln(C)
dC
=
1
C
and
d
2
ln(C)
dC
2
=
1
C
2
.
As a result, the risk premium is given by

1
2
Var(z)
u

(C

)
u

(C

)
=
1
2
2, 500, 000
1
C
=
1
2
2, 500, 000
1
50, 000
= 250.
46
Exercise 4. Suppose the payos from the stock and the risk free bond are as in Example 3. Let
the investors preferences be given by u(C) = ln(C). How much does the stock price have to fall
from S
0
= 59.52, so that this investor purchases the stock?
Exercise 5. Suppose we have a utility function with derivatives of order n+1. Find a more accurate
formula for the risk premium in terms of the higher order derivatives of the utility function.
Exercise 6. (a.) Suppose the utility function is linear in Figure 5. What happens to the risk
premium in Theorem 1.1? Why do we call this person risk neutral?
(b.) Now suppose the utility function in Figure 5 is curved toward the origin rather than away from
the origin. What happens to the risk premium in Theorem 1.1? What would you call an individual
with this type of preferences?
Given Theorem 1.1, Arrow introduced the following denitions of risk aversion.
Denition 5: The measure of an investors absolute risk aversion is
A(C) =
u

(C)
u

(C)
,
where C is the investors consumption without undertaking the actuarially fair gamble.
As a result, according to Theorem 1.1, the risk premium is given by

1
2
Var(z)A(C

).
Denition 6: The measure of an investors relative risk aversion is
R(C) =
u

(C)
u

(C)
C,
where C is the investors consumption without undertaking the actuarially fair gamble.
Remark: This measure of risk is called relative risk aversion since a multiplicative random variable
e
z

C rather than a additive random variable

C +z leads to the risk premium formula

1
2
Var(z)R(C

).
Exercise 7. The example in Figure 5 is a multiplicative random shock where e
z
1
= u and e
z
2
= d.
As a result consumption is given by C
u
= e
z
1
C

in the good state and C

d
= e
z
2
C

in the bad state.

Prove Theorem 1.1 for the case of these multiplicative shocks.
Example 5: Suppose the investors absolute risk aversion is a decreasing function of consumption.
In particular, let A(C) =
2

C
. Suppose an average investor has $50,000 to consume per year. For the
actuarially fair gamble in Example 1, the investor is willing to pay

1
2
Var(z)A(C

) =
1
2
2
50, 000
25, 000, 000 = $500.
47
to avoid this gamble.
We can use this result to explain why a risk averse individual purchases various types of insurance
such as health and life insurance. Suppose you have a car worth $5,000 and you have a 50% chance
that you would have an accident in which your car will be destroyed over the next year, since you
are a bad driver. If your absolute risk aversion is like example 5, then you are willing to pay an
insurance company $500 per year for an auto insurance policy, which pays for the automobile if it
is destroyed. Thus, insurance company makes money by reducing risk for individuals in exchange
for an insurance premium.
8 Risk Aversion and the Investors Utility Function
We now want to investigate the relation between risk aversion and the functional form of the utility
function of an investor. We want to know how risk aversion changes with the standard of living of
a person in order to gain some insight into investor behavior. Since an investor has less absolute
risk aversion as his consumption increases, A(C) must be a decreasing function, that is
A

(C) < 0. (8.7)

Taking the derivative of the formula for absolute risk aversion (using of the quotient rule) we get:
A

(C) =
u

(C)
2
u
(3)
(C)u

(C)
u

(C)
2
.
Therefore A

(C) < 0 is equivalent to

u

(C)
2
u
(3)
(C)u

(C) < 0. (8.8)

Individuals with a higher standard of living are more willing to take on gambles, and so their utility
function should satisfy condition (8.8).
Example 6: If A

(C) < 0 for people, then investors like Warren Buett or Bill Gates would be
willing to take on more risk than the average person. This helps to explain why Berkshire Hathaway
is willing to insure other insurance companies against catastrophes such as the fall of the World
Trade Center. It also helps to explain why Hedge funds, who invest for wealthy investors, would
take on more risk.
Exercise 8. For the logarithmic utility function nd A

(C) < 0. Does this utility function lead to

increasing or decreasing absolute risk aversion.
We now want to consider a class of utility functions which would allow for decreasing absolute
risk aversion. Below, we use the simplest functional form for absolute risk aversion such that the
rst derivative is negative. We consider the following general form:
A(C) =
1
a +bC
, so that A

(C) =
b
(a +bC)
2
, (8.9)
where a and b are constants. As a result, b > 0 would correspond to decreasing absolute risk
aversion.
48
Theorem 8.1 An investor with absolute risk aversion given by (8.9) has a utility function given
by one of the following three formulae, where K and L are any constants.
Case 1: If b = 0 and b = 1 and =
1
b
, then
u(C) = K
1
1
[a +bC]
1
+L;
Case 2: If b = 1, then
u(C) = K ln(a +C) +L;
Case 3: If b = 0, then
u(C) = Kae

C
a
.
Remark: Note that we use the general constant k in each of the three formulae since multiplication
by any constant will not change the optimal behavior of the investor. Case 3 is called constant
absolute risk aversion, since A(C) is constant (A(C) =
1
a
). Also, the case a = 0 is called
constant relative risk aversion since R(C) is constant. In this case A(C) =
1
bC
, and so
R(C) = A(C)C =
1
bC
C =
1
b
.
Note that we cannot have a = 0 = b.Remember also that we are considering the case of decreasing
absolute risk aversion, so b 0 in all the cases of Theorem 1.2 by assumption.
Proof: Recall that
A(C) =
u

(C)
u

(C)
=
1
a +bC
, where a and b are xed parameters.
With this in mind, let us prove each of the cases of the theorem individually.
Case 1: In this case, b = 0, b = 1, and =
1
b
. Also, we have the following two equations:

(C)
u

(C)
dC = ln[u

(C)] +K and

1
a +bC
dC =
ln[a +bC]
b
+K,
where K is the constant of integration. However, both integrals are representations of

A(C)dC,
so
ln[u

(C)] =
ln[a +bC]
b
+K,
where we have altered the constant of integration K without losing equality. After some manipula-
tion of this equation, and once again simplifying the constant of integration, we arrive at
u

(C) = K[a +bC]

1
b
.
Integrating both sides of this equation with respect to C, we get
u(C) = K
1
1
1
b
[a +bC]
1
1
b
+L,
where L is another constant of integration. Then, substituting in , we arrive at the correct formula
for Case 1:
u(C) = K
1
1
[a +bC]
1
+L.
49
Case 2: In this case, we have b = 1, so clearly substituting this into the equation from the rst
case would yield an undened solution. Therefore, we must start again with the rst step. So, we
have A(C) =
1
a+C
, giving us the following two representative integral equations:

(C)
u

(C)
dC = ln[u

(C)] +K and

1
a +C
dC = ln[a +C] +K.
These equations can be combined to give
ln[u

(C)] = ln[a +C] +K,

which simplies by formal manipulation to
u

(C) = K
1
a +C
.
Integrating both sides of this equation, we get the nal formula for Case 2:
u(C) = K ln(a +C) +L.
Case 3: This case is the simplest. Since b = 0, we have A(C) =
1
a
. Therefore, by taking a step
similar to the rst step in the proofs of Cases 1 and 2, we get two integral equations of forms of
A(C):

(C)
u

(C)
dC = ln[u

(C)] +K and

1
a
dC =
C
a
+K.
Accepting a change in the constant of integration K, these equations can be combined as
ln[u

(C)] =
C
a
+K,
which by manipulation simplies to
u

(C) = Ke

C
a
.
Then, through a simple integration of this equation, we arrive at the following formula for the third
case:
u(C) = Kae

C
a
.
This completes the proof of Theorem 1.2.
Remark: Note that it is traditional to set L = 0 in Cases 1 and 2 above, since this additive constant
of integration does not eect optimal investment decisions. Also, it is standard to set K = 1 in all
cases for simplicity. However, we have chosen to be explicit in this lecture by including them.
References
Arrow, Kenneth J. (1971). Essays in the theory of risk-bearing. North-Holland, Amsterdam.
Cvitani c, J. and F. Zapetatero, Introduction to the economics and mathematics of nancial
markets, MIT Press, Boston (2004) pp.104-110.
50