Flashcards in Utility Theory Deck (14)

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1

## Expected Utility

### quantification of the DMs preferences towards an outcome under risk

2

## Utility Curve

###
Utility is a function of reward U(r)

As the reward increases, the marginal utility gets smaller - Law of diminishing marginal return

3

## Certain Monetary Equivalent

### Guaranteed return that someone would accept now, rather than taking a chance on a higher, but uncertain, return in the future.

4

## Types of Utility functions

###
Risk averse conditions

Risk taking conditions

Risk neutral conditions

Turning Point

5

## Risk averse conditions (Utility function)

###
Concave

CME < EMV

6

## Risk neutral conditions (Utility function)

###
Linear

CME = EMV

7

## Risk Taking conditions (Utility function)

###
CME > EMV

Convex

8

## Turning Point Condition (Utility function)

###
risk taking to a point then switch to risk averse

depends on the strategy you can afford

9

## Prospect Theory

###
assumes that losses and gains are valued differently, and thus individuals make decisions based on perceived gains instead of perceived losses

Has a turning point

10

## Insurance Problem

###
Insurance company and customer have varying opinions of risk

Creates a trading margin between the different CME values

Both CME < EMV

11

## Von Neumann-Morganstern Axioms

###
Complete Ordering

Continuity

Independence

Unequal Probability

Compound Lottery

12

## Complete Ordering Axiom

###
If r1 > r2

and r2 > r3

then r1 > r3

13

## Continuity Axiom

### for any gamble, there exists some probability such that the decision-maker is indifferent between the "best" and the "worst" outcome.

14