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IAI Actuarial Core Principles · Economic Modelling · Rational choice theory and utility

Under the expected utility theorem, an investor with utility function U(w) ranks two uncertain prospects by which criterion?

The investor ranks prospects by expected utility, E[U(W)], weighting the utility of each outcome by its probability. Expected monetary value is relevant only to a risk-neutral investor, so ranking by payoff, variance or worst case does not follow from the expected utility theorem.

  1. AThe prospect with the higher expected monetary payoff always
  2. BThe prospect with the lower variance of payoff always
  3. CThe prospect with the higher expected value of U(w) over the outcomesCorrect
  4. DThe prospect whose worst outcome is highest
  5. The prospect with the higher expected payoff divided by its standard deviation

Explanation

Expected utility theory says a rational investor chooses the prospect with the highest E[U(W)]. Expected payoff alone is only right for a risk-neutral investor. Variance or maximin rules are different criteria and are not what the theorem states.

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