![]() The shape of the utility function of wealth in all cases are illustrated in the figure. Here, the certainty equivalent is HIGHER than the expected value. He or she gains more for a rise in wealth than he or she loses for an equivalent fall in wealth. He or she would be willing to pay more than the expected payoff to participate in the investment. ![]() Thus, the certainty equivalent EQUALS the expected value.įinally, there’s the risk-seeking individual. Thus, he or she would be willing to pay the expected pay-off of $75. This person experiences the same utility whether he gains or loses a given amount of wealth. Next, let’s consider a risk-neutral person. In this case, the certainty-equivalent is LESS than the expected value. Thus, they would be willing to pay LESS than $75 for an uncertain but expected pay-off of $75. this means that he or she will suffer a greater loss of utility for a given loss of wealth than they gain in utility for the same rise in wealth. Now, let’s consider a number of examples. Thus, the investment will pay back on average $75. This is the amount of money a person is willing to pay to participate in an investment with an equal probability of the investment paying back immediately $50 or $100. (Britain’s equivalent for a distribution utility) to try out new technology. An electric utility should not be viewed or regulated as. To determine whether investors are in fact risk-averse, we can use certainty equivalent returns. Utilities need revenue certainty to make investments. They may also be risk-seeking or risk-neutral. Behavioral finance, however, argues that individuals are not necessarily risk-averse. Traditional finance assumes that individuals are risk-averse and prefer greater certainty to less certainty.
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