Utility function and investors behavior on the capital market

Students : Custura Ruxandra (group 1) Imre Botond (group 2)

Utility function and investors behavior on the capital market

Properties of utility functions on the capital market: 1. More is preferred than less This attribute is also known as non-saturation and it supposes than an utility function for X+1 value will always be higher than utility for an X value. This supposes that an investor will always choose an investment with a higher result. Markowitz analyses utility functions as a function of wealth at the end of the period, in which a higher wealth (patrimony), is preferred to a smaller one. Hence, the utility function increases if the wealth increases, so first order derivate of this function, marginal utility, is higher than 0. Utility function is increasing towards wealth and the utility slope is positive.

2. Risk preference of the investor There are 3 kinds of investors: Investors with risk aversion (riskphobic) Neutral to risk investors (indifferent) Investors with preference for risk (riskphile) This classification according to risk can be defined in the terms of a fair gamble. This is defined as an event in which the estimated value is equal to the cost. If the gained quantity multiplied with winning probability is to lost quantity multiplied with probability to lose, then we have a fair gamble. An investor with risk aversion will refuse such an arrangement. Example: Investment Result 2 0 Table 1 Refuse of investment Result 1

Probability

Probability 1

To be observed that fair gamble means an estimated value of the investment * 2 + * 0 = 1 is equal with the cost of investment.

Risk Aversion
If an investor prefers not to invest in a fair gamble (has aversion to risk), it means that the estimated utility for denying the investment is higher than the one for investment. U(1)>1/2U(2) + 1/2U(0) Or multiplying with 2 and rearranging: U(1) U(0) > U(2) U(1) This means that o wealth modification from 0 to 1 is higher in utility than from 1 to 2, or utility function of an investor with risk aversion has higher values for the growth from 0 to 1

than from 1 to 2. Because of that, an investor with risk aversion will have a negative second order derivate of utility function towards the wealth. Therefore, for an investor with risk aversion the relation is accomplished:

Risk Indifference
For an investor with risk indifference (neutral) : U(1) = (1/2)U(2) + (1/2)U(0) Or U(1) - U(0) = U(2) - U(1) This shows that for the utility function of a neutral with risk investor an increase of his wealth from 0 to 1 is equal with the increase from 1 to 2. Therefore, second order derivate of utility function for neutral with risk investor is equal to 0.

Risk Preferrence
Risk preferrence assumes that the investor selects to play fair gamble, which means that utility function for investment has to be higher than the one for denying it : (1/2)U(2) + (1/2)U(0) > U(1) Or U(2) - U(1) > U(1) - U(0) For an investor with risk preference, the increase of the utility from 1 to 2 is higher than the increase from 0 to 1. Functions with this property have their second derivate higher than 0.

Therefore, second order derivate of investments on the capital market has the following properties : Condition Risk aversion Risk indifference Risk preference Table 2 Property of utility function U(W)<0 increasing concave slope U(W)=0 to the right U(W)>0 increasing conveze slope

Indifference curves of the investors are represented in Graphic 1, according to an utility function in rentability, risk space U( ) or U( ):

Where I1 investor with risk preference will have a decreasing concave slope I2 neutral to risk investor, right with 0 slope I3 investor with risk aversion will an increasiong convex slope

Graphic 1 In Graphic 2, the indifference curves of the investors are represented according to their utility towards their fortune (patrimony) in the following classification:

neutral to risk investor, right with positive slope

investor with risk preference, increasing convex slope

investor with risk aversion, increasing concave slope

3. The way in which the preference of the investors change according to the growth of their fortune. In this case, it is taken in consideration what happens with his investment with risk if the fortune an investor increases. Example: Suppose that the wealth of an investor increases with an absolute value X. Will he invest less, equal or more to that value ? - if the investor raises the value of the investment in riskful assets the same time with the increasing of weath in absolute value, he is an investor who decreases the absolute aversion to risk with the weath increase. - if the investor remains constant in investments with risk with the increase of his wealth, he is an investor with constant absolute aversion to risk. - if the investor reduces the investment in assets with risk, and same time increases his wealth, he is an investor with increased absolute aversion. We note with A(W) the function, which will measure the absolute aversion to risk (riskfobia):

This function is the opposite ratio of second and first derivative of the utility function, and is called the function of absolute aversion to risk and it characterizes the investors behavior based on the absolute increase of their wealth, conform Table 3 :

Condition

Definition

The property of absolute aversion to risk function

Increase in absolute aversion to risk Constant absolute aversion Decrease absolute aversion Table 3

With the increase in wealth, the investor lowers his participation with assets with risk. With the increase in wealth, the investor does not modify his participation with assets with risk.

A(W)>0

A(W)=0

risk

With the increase in patromony, the investors participation with riskful assets increases.

A(W)<0

In Table 3 are presented utility functions that model this behaviour, fulfilling the corresponding functions for functino A(W). 4. Percentage measure change of investments in assets with risk with the proportianal increase of wealth. The relative aversion to risk can be measured with the function R(W), named as the relative risk aversion function.

Depending on the property of this function, we can detect three different types of relative aversions to risk, that occur with the increasing wealth, conform Table 4.

Condition Increased aversion risk

Definition With the increase in patrimony the investor decreases the investment percentage in assets with risk. With the increase in patrimony the percentage of investment in assets with risk does not change. With the increase in patrimony, the percentage of investment in assets with risk increases.

Property of relative risk aversion function R(W)>0

Constant relative risk aversion Decrease in relative risk aversion Table 4

R(W)=0

R(W)<0

R(W) is the relative aversion to risk function whose first order derivative if greater than zero, describes an investor with a relative increase in risk adversity, meaning that with the increase in wealth, such an investor will allocate a smaller investment in assets with risk than the proportion in which his wealth did increase. We analyze the case of a quadratic utility functions and determine the functions and determine the functions A(W) and R(W), as well as their first and second order derivatives. Lets consider the following utility funciton: U(W)= W b W2 With first and second ordered derivatives:

The first condition :

The absolute and relative aversion functions for this quadratic utility function are:

With other words, and investor with a quadratic utility function format (with b>0) has the aversion to risk, because the second derivative of the utility function is negative A(W) is bigger than zero, so the investor has an increased absolute aversion to risk. R(W) is also bigger than zero, that implies an investors increased relative aversion to risk. To present graphically the quadratic utility function, we choose four different values for b (0,3 ; 0,1 ; 0,05 ; 0,01) and then we calculate the value of the utility functions U1, U2, U3 and U4, for different values of W into consideration the relationship: . The graphical representation is shown in figure II-6.

Graphic 3

We can observe the form of the 4 utility functions, similar to the allure of the investor with risk aversion. It is obvious theat the quadratic function concave has a bigger than zero first order derivative. Thanks to the property of function U3: U(4) - U(0) > U(8) - U(4) or m > n

We can conclude that the U3 function has a second order derivative smaller than zero, meaning that it is the utility function for an investor with aversion to risk. The A(W) function for quadratic utility function is represe

Graphic 4 From the direction of the curve, we can conclude that its first order derivative is bigger than zero, due to the increasing slope function. We can estimate that the quadratic utility function presented characterizes the investor with increasing absolute adversity to risk, or in other words, if the investors wealth is increasing, his absolute investment will decrease. So if he has a patrimony of 1000 m.u. and has a current investment of 500 m.u. in assets with risk and if his wealth doubles, meaning 2000 m.u., that would mean that the investor will invest less than 500 m.u. in assets with risk. The functions of Ri(W) are presented in figure II-8, whose form indicated the fact that that its first order derivatives are positive, thanks to the positive slope, so the quadrativ utility funciton characterizes the investor from the increased relative adversity to risk point of view. So if the patrimony of the investor increases, he will decrease the investment in assets with associated risk. E.g.: if his wealth is 1000 m.u. and has 25% investment in assets associated with risk, when his wealth doubles to 2000 m.u., the investment in risk associated assets with decrease under 25%.

The R(W) function

Graphic 5 This quadratic utility function is the best way to model the utility analysis theough average value, so the rational investor has risk aversion, with an absolute and relative growth pf the adversion to risk To demonstrate the connection between the quadratic utility function and the utility function U ( ), we use the following argument:

We consider wealth W as a random variable. E is the expected value operator. Squared:

The expected value of the sum of random variables is equal to the sum of the expected value of random variables:

Going on:

wherefrom:

On the other hand we need to calculate the estimated value (expected value) of the quadratic utility function, which we used as an example:

Replacing conform the previous formula, we obtain the following:

U(W)= W b W2 U( )=

So the utility function being quadratic, can be expressed as a function of variables and as an average. (E(W) is the average value and the variant is ( ) ).

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