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IAI Actuarial Core Principles · Business Management · Decision-making process, attitude to risk and competition

Meera, a finance manager at an Indian manufacturing firm, is offered a choice between a certain gain of Rs 50 lakh and a project with a 50% chance of Rs 100 lakh and a 50% chance of nothing. She chooses the certain Rs 50 lakh. In utility theory, what does this choice indicate about her attitude to risk?

She is risk averse. The gamble's expected value equals the certain Rs 50 lakh, yet she prefers certainty. This shows diminishing marginal utility of wealth and a concave utility function, whereas a risk-neutral decision-maker would be indifferent.

  1. AShe is risk averse, because she prefers the certain amount to a gamble with the same expected valueCorrect
  2. BShe is risk neutral, because both options have the same expected value
  3. CShe is risk seeking, because she avoids the possibility of earning nothing
  4. DShe has a convex utility function over wealth
  5. She has a constant marginal utility of wealth

Explanation

The gamble has an expected value of 0.5 x 100 = Rs 50 lakh, equal to the certain amount. Preferring certainty at equal expected value is the definition of risk aversion, which corresponds to a concave utility function with diminishing marginal utility. A risk-neutral person would be indifferent between the two.

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