Lec 1

Financial Markets
Technical Analysis
Asso. Prof. Moshera Ahmad
Utility theory
A Preview of Things to Look For
Utility theory
• A Preview of Things to Look For
• 1 Utility theory
• Introduction
• The expected utility theorem
• Derivation of the expected utility theorem
• 2 The expression of economic characteristics in terms of utility
functions
• 2.1 Non-satiation
• 2.2 Risk aversion
This chapter focuses on utility theory as applied to investment choices.
In economics, ‘utility’ is the satisfaction that an individual obtains from a
particular course of action.

In Section 1 we introduce utility functions and the expected utility theorem. This
provides a means by which to model the way individuals make investment choices.

Section 2 describes the properties that are normally considered desirable in utility
functions to ensure that they reflect the actual behaviour of investors. Chief
amongst these are:
• non-satiation, a preference for more over less, and
• risk aversion, a dislike of risk.
1. Utility theory
In this section we use utility theory to consider situations that involve
uncertainty, as will normally be the case where investment choices are
concerned.
Uncertainty
Utility functions
Uncertainty
• In what follows, we assume any asset that yields uncertain outcomes
or returns, i.e. any risky asset, can be characterised as a set of
objectively known probabilities defined on a set of possible
outcomes.
For example, Equity A might offer a return to Investor X of either -4 %
or +8% in the next time period, with respective probabilities of ¼ and
¾.
Question
Each year, Mr A is offered the opportunity to invest £1,000 in a risk fund. If
successful, at the end of the year he will be given back £2,000. If unsuccessful, he
will be given back only £500. There is a 50% chance of either outcome. Calculate
the expected rate of return per annum on the investment.
Solution
We can calculate the expected rate of return as follows:

Given the uncertainty involved, the rational investor cannot maximise utility with
complete certainty. We shall see that the rational investor will instead attempt to
maximise expected utility by choosing between the available risky assets.
 Utility functions
In the application of utility theory to finance and investment choice, it is
assumed that a numerical value called the utility can be assigned to each
possible value of the investor’s wealth by what is known as a ‘preference
function’ or ‘utility function’.

Utility functions show the level of utility associated with different levels of
wealth. For example, Investor X might have a utility function of the form:
U(w) = log(w)
where w is the current or future wealth.
1.2 The expected utility theorem

The theorem has two parts.

• The expected utility theorem states that a function, U(w), can be
constructed as representing an investor’s utility of wealth, w, at
some future date.
• Decisions are made in a manner to maximise the expected value of
utility given the investor’s particular beliefs about the probability of
different outcomes.
In situations of uncertainty it is impossible to maximize utility with
complete certainty. For example, suppose that Investor X invests a
proportion a of his wealth in Equity A and places the rest in a non-
interest-bearing bank account. Then his wealth in the next period
cannot be predicted with complete certainty and hence neither can his
utility.

It is possible, however, to say what his expected wealth equals. Likewise

if the functional form of U( w ) is known, then it is possible to calculate
his expected utility.
The expected utility theorem says that when making a choice an
individual should choose the course of action that yields the highest
expected utility – and not the course of action that yields the highest
expected wealth, which will usually be different.
Question
• Derive an expression for the expectation of Investor X’s next-period
wealth if he invests a proportion a of his current wealth w in Equity A
(which pays –4% or +8%, with respective probabilities ¼ and ¾) and
the rest in a non-interest-bearing bank account.
• Solution
Calculating the expected utility
• Suppose a risky asset has a set of N possible outcomes for wealth (w1 ,
...,wN ) , each with associated probabilities of occurring of (p1 ,..., pN ) ,
then the expected utility yielded by investment in this risky asset is
given by:

• So the expected utility is a weighted average of the utilities associated

with each possible individual outcome.
State an expression for the expectation of the next-period utility of Investor X,
again assuming that he invests a proportion a in Equity A and the rest in a non-
Question
interest-bearing bank account.
He has the utility function U(w) = log(w) .
Solution

E [U(w)] = 0.25{log((1-0.04a)w)}+ 0.75{log((1+ 0.08a)w)}.

Note that a risk-free asset is a special case of a risky asset that has a probability of
one associated with the certain outcome, and zero probability associated with all
other outcomes
……………………………………………………………………………………………………………………………..
if he invests a proportion a of his current wealth w in Equity A (which pays –4% or
+8%, with respective probabilities ¼ and ¾) and the rest in a non-interest-bearing
bank account.
Question
Investor A has an initial wealth of $100, which is currently invested in a non-
interest-bearing account, and a utility function of the form:
U(w) =log(w)
where w is the investor’s wealth at any time.
Investment Z offers a return of -18% or +20% with equal probability.
What is Investor A’s expected utility if nothing is invested in Investment Z?
Solution;
log (100)= 4.605
Investor A has an initial wealth of $100, which is currently invested in a non-
interest-bearing account, and a utility function of the form:
U(w) =log(w)
where w is the investor’s wealth at any time.
Investment Z offers a return of -18% or +20% with equal probability.
(i) What is Investor A’s expected utility if nothing is invested in Investment Z?
• (ii) What is Investor A’s expected utility if they’re entirely invested in
Investment Z?
• (iii) What proportion a of wealth should be invested in Investment Z to
maximise expected utility? What is Investor A’s expected utility if they invest
this proportion in Investment Z?

Solution;
(i) If nothing is invested in Investment Z, the expected utility is:
log (100)= 4.605
• (ii) What is Investor A’s expected utility if they’re entirely invested in
Investment Z?

0.5 * log(0.82 * 100) + 0.5 *log(1.2 * 100) = 4.597

(iii) If a proportion a of wealth is invested in Investment Z, the expected utility is
given by:

We differentiate with respect to a to find a maximum:

We then set equal to zero:

Checking to see if this gives a maximum:

This gives a negative value so it is a maximum.
Finding the expected utility from investing 27.77% in Investment Z:
1.3 Derivation of the expected utility theorem

The expected utility theorem can be derived formally from the

following four axioms.
In other words, an investor whose behaviour is consistent with these
axioms will always make decisions in accordance with the expected
utility theorem.
1. Comparability
2. Transitivity
3. Independence
4. Certainty equivalence
 Comparability
An investor can state a preference between all available certain outcomes.
In other words, for any two certain outcomes A and B, either:
A is preferred to B,
B is preferred to A,
or the investor is indifferent between A and B.
These preferences are sometimes denoted by:
U(A) >U(B), U(B) >U(A) and U(A) =U(B)
Note that A and B are examples of what we previously referred to as wi .
Transitivity
If A is preferred to B and B is preferred to C, then A is preferred to C.

This implies that investors are consistent in their rankings of outcomes.

Independence
If an investor is indifferent between two certain outcomes, A and B,
then they are also indifferent between the following two gambles:
(i) A with probability p and C with probability (1 - p)
(ii) B with probability p and C with probability (1 - p).
Hence, if U(A) = U(B) (and of course U(C) is equal to itself), then:
p U(A) + (1–p) U(C) = p U(B) + (1–p) U(C)
Thus, the choice between any two certain outcomes is independent of
all other certain outcomes.
Certainty equivalence
Suppose that A is preferred to B and B is preferred to C. Then there is a unique
probability, p, such that the investor is indifferent between B and a gamble giving
A with probability p and C with probability (1 - p).
Thus if:
U(A) >U(B) >U(C)
Then there exists a unique p ( 0 < p <1 ) such that:
pU(A) + (1 – p)U(C ) =U(B)
B is known as the ‘certainty equivalent’ of the above gamble.

It represents the certain outcome or level of wealth that yields the same certain
utility as the expected utility yielded by the gamble or lottery involving outcomes A
and C.
The four axioms listed above are not the only possible set of axioms, but they are the most commonly used.
Question
• Suppose that an investor is asked to choose between various pairs of
strategies and responds as follows:

• Assuming that the investor’s preferences satisfy the four axioms

discussed above, how does the investor rank the five investments A to
E?
Solution
From the responses we can note immediately that:
B > D, D > A, C = D, B > E, C > A, D = E
Hence, transitivity then implies that:
B>D>A
C=D=E
And so we have that:
B>C=D=E>A
Quiz
Time
• Each year, Mr A is offered the opportunity to invest £2,000 in a risk
fund. If successful, at the end of the year he will be given back £2,600.
If unsuccessful, he will be given back only £1500. There is a 50%
chance of either outcome. Calculate the expected rate of return per
annum on the investment.

• Derive an expression for the expectation of Investor X’s next-period

wealth if he invests a proportion a of his current wealth w in Equity A
(which pays –6% or +9%, with respective probabilities ¼ and ¾) and
the rest in a non-interest-bearing bank account.
2. The expression of economic
characteristics in terms of utility
functions
2.1 Non-satiation
2.2 Risk aversion