IAI Actuarial Core Principles · Economic Modelling · Rational choice theory and utility
Which statement about the Arrow-Pratt measures of risk aversion is correct?
Absolute risk aversion is defined as minus the second derivative of utility divided by the first derivative, -U''(w)/U'(w). Relative risk aversion multiplies this by wealth. A risk-neutral investor has zero absolute risk aversion.
- AAbsolute risk aversion is -U'(w)/U''(w)
- BAbsolute risk aversion is -U''(w)/U'(w)Correct
- CRelative risk aversion is -U''(w)/U'(w)
- DRelative risk aversion equals absolute risk aversion divided by wealth
- A risk-neutral investor has a negative absolute risk aversion
Explanation
Absolute risk aversion is A(w) = -U''(w)/U'(w). Relative risk aversion is wA(w), i.e. multiplied by wealth, not divided. Risk neutrality gives zero.
Did you get it right without looking?
One question tells you little. A timed set on Rational choice theory and utility shows your real accuracy, how long you take and where you lose marks.
More Rational choice theory and utility questions
- Which statement about the von Neumann-Morgenstern axioms and expected utility is correct?
- An investor has utility U(w) = -e^(-0.0002w). Her absolute risk aversion A(w) = -U''(w)/U'(w) is what?
- Which feature of a utility function U(w) implies that an investor is risk averse under expected utility theory?
- In prospect theory, as proposed by Kahneman and Tversky, outcomes are evaluated mainly as gains or losses relative to a reference point. Whi…
- Which observation is most directly a challenge to expected utility theory's independence axiom, as shown by the Allais paradox?
- In the Kahneman-Tversky framing experiments, people choose a certain gain over a gamble with the same expected value, yet choose a gamble ov…