Lecture 13: Risk Aversion and the Capital Asset

Pricing Theorem
The topic of this lecture is called the Capital Asset Pricing Model, and it is
in some ways the high point of the class. While the theory has not worked
out as well as it was hoped or thought, it has been quite a great achievement.
Hypothetically, if everybody hedged it would mean that everybody would get
a completely riskless payo which is impossible since there is real risk in the
economy. That means that even if everybody tried to hedge all risks as much as
they could by diversifying, in some states things will be in the aggregate worse
than they will be in other states because some risk will always remain.
The consequence of that is if you are going to buy an asset that pays something that is riskless, you are going to pay the discounted expected return of
the asset, but if youre going to buy an asset that is risky you are going to need
a higher rate of return so the price will be less than the expected discounted
payo. Thus far we have not properly addressed how to measure risk and riskaversion, and how that will aect the price of things. This is the topic of the
last couple of lectures.
The rst person to confront the problem of risk aversion and propose a
mathematical solution was the mathematician Daniel Bernoulli and his cousin
Nicholas Bernoulli. The Bernoullis were a famous mathematical family, and one
of the brothers went o to St. Petersburg where he ended up dying shortly afterwards, but he noticed the following puzzle called the St. Petersburg Paradox.

0.1

Risk Aversion

The following example is an excerpt from Daniel Bernoullis original paper translated from Latin and published in Econometrica in 1954 called "Exposition of
a New Theory on the Measurement of Risk":
"My most honorable cousin the celebrated Nicolas Bernoulli, Professor utriusque
iuris at the University of Basle, once submitted ve problems to the highly distinguished mathematician Montmort. The last of these problems runs as follows:
Peter tosses a coin and continues to do so until it should land "heads" when it
comes to the ground. He agrees to give Paul one ducat if he gets "heads" on
the very rst throw, two ducats if he gets it on the second, four if on the
third, eight if on the fourth, and so on, so that with each additional throw the
number of ducats he must pay is doubled. Suppose we seek to determine the
value of Pauls expectation. My aforementioned cousin discussed this problem
in a letter to me asking for my opinion. Although the standard calculation
shows that the value of Pauls
expectation is innitely great, it has, he said, to be admitted that any fairly
reasonable man would sell his chance, with great pleasure, for twenty ducats.
The accepted method of calculation does, indeed, value Pauls prospects at innity though no one would be willing to purchase it at a moderately high price."
Indeed the value of this bet is:

1
1
1
1
1 + 2 + 4 + ::: + n 2n 1 = 1
(1)
2
4
8
2
The essence of Bernoullis argument was that the solution must be that
people dont care about the dollar payo. They care about the utility of the
dollar payo. So lets phrase the problem in a utility function:
1
1
1
1
(2)
U (1) + U (2) + U (4) + ::: + n U (2n 1 )
2
4
8
2
Since the utility function is concave, utility increases with more money but
by less and less. For instance, if we use the natural log as the utility function
then:
1
1
1
1
ln(1)+ ln(2)+ ln(4)+:::+ n ln(2n
2
4
8
2

)=

n
X
1
ln(2n
n
2
i=0

) = ln(2)

n
X
n
i=1

1
2n

= ln(2)

(3)
Thus, instead of caring about expectation, if you care about the expected
utility one can explain why the average person was willing to pay so little.
People do not look at expected payos, they look at expected utility of payos,
and the utility should have a concave feature that more and more payo adds
on the margin less and less utility.
A concave function has the property that if you have a payo XA and a
payo XB and youve got a utility U (XA ) and U (XB ) with a 50/50 bet of either
getting XA or getting XB the average utility will be 1=2U (XA ) + 1=2U (XB ).
However, because of the concavity:
1=2U (XA ) + 1=2U (XB ) < U

XA + XB
2

(4)

The extra you gain by winning the bet, compared to getting the average
for sure, the extra you gain doesnt drive the utility up very much because the
curve is attening out. However, the loss of the same number of dollars is more
important to you than the gain of an equal amount of dollars, and that is why
you would rather get the middle for sure than having a 50/50 chance of going
on the extremes.
Therefore, Bernoulli pointed the way to the modern theory of risk aversion,
which is to just assume that risk aversion in modern economics means people
care about discounted expected discounted utility where the utility is concave.
The modern theory of risk aversion explains why people would rather have
things for sure rather receive the outcome of a gamble. In addition, with the
concrete utility function you can nd out exactly how much you are willing to
pay to transform the risky gamble into a safe gamble.
From the very beginning we have thought about peopleas maximizing utility.
Actually this risk aversion with diminishing marginal utility is exactly the same
thing we have been thinking about all along anyway, diminishing marginal utility

for consumption. The very assumption of diminishing marginal utility that we

made from the beginning is also explaining risk aversion.
The most simple utility function is either the log or the quadratic: U (X) =
a + bX cX 2 . Adding a constant is never going to change anything, so we can
write this as:
1
X2
(5)
2
This is convenient to use because lets suppose now that you have got a
random payo where with probability 1 you get X1 , with probability 2 you
get X2 , and with probability s you get Xs . That means the utility function is
going to equal:
U (X) = X

S
X

1
Xs2 = f (E(X); V arX)
2

Xs

s=1

S
X

S
1 X
2 s=1

s Xs

s=1

(6)

2
s Xs

(7)

We are just saying that people do not care about the payos. They have
to evaluate getting X1 ; X2 or XS . They are going to multiply the payo by
the expectation but not look at the payo itself, just look at the utility of the
payo. However:

V arX =

S
X

s (Xs

EX)2 =

S
X

s Xs

s Xs EX

s=1

s=1

s=1

S
X

S
X

2
s (EX)

(8)

s=1

Since EX is a constant we have that:

V arX =

S
X

s Xs

(EX)2

(9)

s=1

and the utility function becomes:

1
1
(EX)2
V arX
(10)
2
2
So far we have assumed people only care about the expectation. However,
we know they dont only care about the expectations since hedge funds and
everybody else are going to hedge. People care about the utility and not about
just the expected payo. Thus, of all the myriad of utility functions (i.e., log,
e aX , X r etc.) we are going to deal with the quadratic because it has the simple
property that in evaluating an entire risky proposition people care about the
expectation but they are punishing themselves for getting a bad variance.
U = EX

Now let us work through an example. There are many rms in the economy
A, B and C, and lets suppose the payos in three states of the world are the
following:

Lets say there are two agents, agent owns A and also 133.5 units of X0
(which is consumption at time t = 0). And owns B & C and 66.5 units of
X0 . One can think of alpha and beta denoting millions of similar agents so that
everything can be scaled by a million. Then:
U =
For instance, agent
traded:

U =

1
1
133:5 + (50
2
4

3
X
1
X0 +
2
s=1

Xs

1
X2
400 s

(11)

would receive the following utility from A if he never

1
1
502 ) + (100
400
4

1
1
1002 ) + (75
400
2

1
752 ) (12)
400

However, this outcome is not very good because he is running an important

risk if state 1 occured. Therefore, agent needs to reevaluate the shares of rm
A, B and C, respectively. Agent has a similar utility:
U =

3
X
3
X0 +
4
s=1

Xs

1
X2
800 S

(13)

Please note that the utility functions include not only (im)patience (as 1/2
and 3/4, respectively), but also risk aversion. Both and have utility functions where the variance has a negative eect. Please note that is more risk

averse. However, both agents are afraid of risk, one being more afraid than the
other. In a world without risk aversion the price of A would be:
1
1
1
50 + 100 + 75
(14)
4
4
2
However, most investors are risk averse since the stock market historically
has had a much higher return than the bond market (i.e., the equity premium
puzzle). Even with the last stock market crash, since 1926 the stock market
has produced on average a return of 9% a year compared to 2.5% in the bond
market. So there is a huge disparity and after over such a long period of time
it cant just be because of luck. Somehow people must have realized the stock
market is riskier, and they wanted a higher return meaning they were paying a
lower price.
The question is that our old methodology for guring out prices taking
expectation and discountingobviously cant be right because it doesnt recognize risk aversion. On the other hand, we always had a utility function from the
beginning, even a quadratic one, so all we have to do is do what we did before
and put in a quadratic utility. Arrow (1951) said to apply the Fisher trick and
assume rm dividends are part of endowments and then look for the general
equilibrium, trading outputs, trading goods, and the value of rms.
Arrow and then Debreu developed the so-called Arrow-Debreu State Contingent Commodities. So, just as Fisher said, an apple today and an apple next
year, even though theyre identical apples, are dierent commodities with different prices because they come at dierent places in time. In fact, most people
would prefer the apple today to the apple next year.
Arrow basically said that an apple in the top state is a dierent commodity
from the same apple in the second state, so it should have a dierent price.
So we have got just our conventional equilibrium according to Arrow where as
long as you have these Arrow state contingent commodities that you can trade
today, you can imagine today buying an apple if state 1 occurs but not having
to get the apple if state 2 or state 3 occurs, and thatll have a price p1 .
And today you could imagine buying the apple if state 2 occurs, a dierent
price from the apple if state 1 occurs, and also an apple if state 3 occurs, which
obviously is going to be more expensive since it has a 50% chance to happen.
This is going to solve the problem because the prices of the Arrow securities
are going to be dierent from the probabilities and that is what will reect the
fact that when everybodys trying to hedge and not everybody can do it youre
going to have to change the tradeos.
We have already seen these Arrow contracts when we talked about the bookies who thought the odds were 60/40, whereby paying 60 cents today the bookie
was going to give you 1 dollar if the Yankees won, or paying 40 cents today the
bookie will give you 1 dollar if the Phillies won. Then we said the nal betting
odds depended on what the other bookies were willing to give and it did not
have to correspond to reality.
To solve for the equilibrium we have to set marginal utility equal to the
price. The Arrow-Debreu equilibrium, is going to involve p0 ; p1 ; p2 and p3 or
(A) = P V

the prices of the Arrow securities (i.e., the present value prices). Price p0 is
what you pay today to get the apple today. p1 is what you pay today to get the
apple a year from now in state 1. These are the present value state contingent
prices.
For we know that:
M Us
M U0
=
p0
ps
Similarly, for

(15)

we know that:
M U0
M Us
=
p0
ps

Given the utility functions of

that:

and

(16)

and imposing that p0 = 1; we get

1
=
2

s (1

1=200Xs )
ps

(17)

3
=
4

s (1

1=400Xs )
ps

(18)

The equations above yield that:

Xs = 200

100

ps

(19)

Xs = 400

300

ps

(20)

In the next step we need to gure out the prices. Now you have to feed
the endowments into the payos and the dividends into the agentsendowments
and then solve for supply and demand:
Xs + Xs = e + e

(21)

which means:
200

ps

+ 400

(22)

= p1 50 + p2 100 + p3 75
1
=
[ 50 + 2 100 + 3 75]
4 1

(23)

and this solves for ps =

(A)

300

ps

= 500

100

= 1=4: Then:

(24)

The price of the riskless asset is then going to be: (1; 1; 1) = 1=4: The
discount rate is 1/4 which implies that the riskless interest rate is going to be
300% (i.e., 1 + r = 1 ). So far risk has not played any role since we got all
6

prices just by doing expectations. Because although

started o owning A
alone which exposed her to a lot of risk, she is going to trade it for B and C
for dierent shares and end up with a consumption of 200 100ps = s (the ratio
ps = s is independent of the state). Thus, she is going to consume the same
amount in every state. She can own equal shares of A, B and C and therefore
she will own a share of the whole economy. In other words, by diversifying
and each get rid of all risk. Instead of calling it diversifying we could call it
hedging.
She will always consume the same thing. Everybody can hedge perfectly
and there is no problem because there is no aggregate risk that anyone has
to be stuck with, and therefore the price is just going to be the same as the
probabilities discounted.
In summary, what we proved by solving for the general equilibrium is that
the price in every state is just going to be 1/4 times the probability. The
consequences are twofold. Number one, the price of all the assets is the same
expectation we naively would have taken before where we used the discount rate
1/4. The second implication is that from the formula for consumption we noticed
that she consumes the same amount in all three states because ps = s = 1=4 in
all three states. Finally, since she holds the same proportion of A, B and C
(they add up to 500, 500, 500), she must have held the same proportion of A,
B and C, a fraction of the market and got a riskless payo.
Next, let us change the endowments and eliminate payo from rm C. Obviously now the total endowment is very contingent. It is 200, 280 and 440,
respectively. Agent would like to hedge her A holding since it is risky, and
similarly B will attempt to hedge B. However, there is no way that each of them
can be perfectly hedged. The problem is the world is short of commodities in
state 1 as there just are not many apples. When everybody wants to hedge
against that state they are all going to be trying to buy Arrow securities in that
state, which means that because there arent as many to buy, the price of Arrow
securities in state 1 is going to be high relative to state 3. Agent is going to
sell some of her A and get some B to diversify, but Bs got so good in state 3
that all of a sudden she is not going to be so worried about state 3 anymore.
However, she will worry about state 1 such that the price is going to have to be
very expensive in state 1.
Solving for equilibrium please note that the utility functions are the same.
Demand in state 1 is:
600

400

p1

= e1 + e1 = 200

(25)

which implies that p1 =

600
which implies that p2 =

600

= 1: In state 2:
p2
= e2 + e2 = 280
2
= 4=5: Finally, in state 3:
400

400

p2
= e2 + e2 = 440
2
7

(26)

(27)

such that p3 = 3 = 2=5: The reason why the prices are slightly higher on
average than they were before is because there is less consumption in the future.
We have suddenly made our future much worse o. So people are more desperate
to consume in the future, so that means the prices of future consumption are
going to be higher.
So we have two eects here. These prices instead of being 1/4 everywhere
are higher because the future looks so much worse. The interest rate is going
to go down. Its not going to be 300% anymore. But more interesting is that
the prices are no longer proportional to the probabilities. The price in state 1
is going to be much higher relative to the probability, namely 100% of it than
the price in state 3 which is only 40% of it. Now the price of A will be:
41
21
1
50 +
100 +
75 = 47:5
(28)
4
54
52
The riskless rate of interest is p1 + p2 + p3 = 7=10 which means that 1 + r =
10=7 or r = 3=7 = 43%: The interest rate went from 300% to 40%, but that is
because we lost all this future consumption. The emphasis however is on the
fact that the prices are no longer proportional to the probabilities.
In conclusion, Arrow has gured out that because not everybody could hedge
that means that the price of an Arrow security is not exactly equal to the
probability. It is relatively high if the economy is poor like in state 1 and
relatively lower if the economy is rich like in state 3. However, by looking at the
nal consumption of and we note something very important. Thus, X1A =
200 100 1 = 100; X2A = 200 100 4=5 = 120 and X3A = 200 100 2=5 = 160:
e A = 400 300 1 = 100; X
e A = 400 300 4=5 = 160
For agent ; we nd that X
1
2
e A = 400 300 2=5 = 280:
and X
3
What is surprising is this consumption is just the sum of the aggregate
endowment. Remember the aggregate endowment is just 200, 280 and 440. For
instance, if agent holds 50 of the bond plus 1/4 of 200 he gets 100. 50 of the
bond plus 1/4 of 280 is 120. 50 of the bond plus 1/4 of 440 is 160. And agent
is going to hold 3/4 of the aggregate endowment (200) minus 50 of the bond
or 100, 3/4 of 280 minus 50 or 160 and 3/4 of 330 minus 50 or 280, respectively.
Therefore in equilibrium despite having a million stocks to choose from and
thousands of states etc, what everybody does is hold the riskless bond, puts
money in the bank and holds the whole stock market.
(A) =