IDEAS home Printed from https://ideas.repec.org/a/inm/ordeca/v5y2008i1p5-9.html
   My bibliography  Save this article

Interpretation of the Risk Tolerance Coefficient in Terms of Maximum Acceptable Loss

Author

Listed:
  • Philippe Delquié

    (INSEAD, Decision Sciences Area, Fontainebleau F-77300, France)

Abstract

Users (or would-be users) of exponential expected utility often seek a concrete, intuitive meaning for the risk tolerance coefficient (RT) that they can grasp and explain to others easily. This paper shows an interpretation of RT as the maximum loss the decision maker is willing to be exposed to at a stated probability level, regardless of the upside potential. As an example, if you are facing a portfolio of projects having a 1 in 20 chance of total loss and you indicate that L is the maximum loss you would tolerate, then your risk tolerance is L /3. Other such examples, which may be better suited to other situations, are presented. In some contexts, this interpretation may be congruent with the way individuals naturally think about their risk-taking propensity, for example, as willingness to be exposed to losses or as in value-at-risk. This interpretation can also be helpful in determining whether assuming exponential utility is adequate for the situation being analyzed, and in eliciting the value of RT. The merits of this approach for thinking about RT are discussed.

Suggested Citation

  • Philippe Delquié, 2008. "Interpretation of the Risk Tolerance Coefficient in Terms of Maximum Acceptable Loss," Decision Analysis, INFORMS, vol. 5(1), pages 5-9, March.
    • Handle: RePEc:inm:ordeca:v:5:y:2008:i:1:p:5-9
    DOI: 10.1287/deca.1080.0105
    as

    Download full text from publisher

    File URL: http://dx.doi.org/10.1287/deca.1080.0105
    Download Restriction: no
    File URL: https://libkey.io/10.1287/deca.1080.0105?utm_source=ideas
    LibKey link: if access is restricted and if your library uses this service, LibKey will redirect you to where you can use your library subscription to access this item
    ---><---

    References listed on IDEAS

    as
    1. James E. Smith, 2004. "Risk Sharing, Fiduciary Duty, and Corporate Risk Attitudes," Decision Analysis, INFORMS, vol. 1(2), pages 114-127, June.
    2. Machina, Mark J, 1982. ""Expected Utility" Analysis without the Independence Axiom," Econometrica, Econometric Society, vol. 50(2), pages 277-323, March.
    3. Ronald A. Howard, 1971. "Proximal Decision Analysis," Management Science, INFORMS, vol. 17(9), pages 507-541, May.
    4. Ronald A. Howard, 1988. "Decision Analysis: Practice and Promise," Management Science, INFORMS, vol. 34(6), pages 679-695, June.
    5. Craig W. Kirkwood, 2004. "Approximating Risk Aversion in Decision Analysis Applications," Decision Analysis, INFORMS, vol. 1(1), pages 51-67, March.
    Full references (including those not matched with items on IDEAS)

    Citations

    Citations are extracted by the CitEc Project, subscribe to its RSS feed for this item.
    as


    Cited by:

    1. Lippman, Steven A. & McCardle, Kevin F. & Tang, Christopher S., 2013. "Using Nash bargaining to design project management contracts under cost uncertainty," International Journal of Production Economics, Elsevier, vol. 145(1), pages 199-207.

    Most related items

    These are the items that most often cite the same works as this one and are cited by the same works as this one.
    1. H Xiong & J Xie & X Deng, 2011. "Risk-averse decision making in overbooking problem," Journal of the Operational Research Society, Palgrave Macmillan;The OR Society, vol. 62(9), pages 1655-1665, September.
    2. C. Barz & K. Waldmann, 2007. "Risk-sensitive capacity control in revenue management," Mathematical Methods of Operations Research, Springer;Gesellschaft für Operations Research (GOR);Nederlands Genootschap voor Besliskunde (NGB), vol. 65(3), pages 565-579, June.
    3. Simone Cerreia-Vioglio & Fabio Maccheroni & Massimo Marinacci, 2017. "Stochastic Dominance Analysis Without the Independence Axiom," Management Science, INFORMS, vol. 63(4), pages 1097-1109, April.
    4. Ali E. Abbas & James E. Matheson & Robert F. Bordley, 2009. "Effective utility functions induced by organizational target-based incentives," Managerial and Decision Economics, John Wiley & Sons, Ltd., vol. 30(4), pages 235-251.
    5. L. Robin Keller, 2010. "From the Editor..," Decision Analysis, INFORMS, vol. 7(3), pages 235-237, September.
    6. Xin Chen & Melvyn Sim & David Simchi-Levi & Peng Sun, 2007. "Risk Aversion in Inventory Management," Operations Research, INFORMS, vol. 55(5), pages 828-842, October.
    7. Steven A. Lippman & Kevin F. McCardle, 2012. "Embedded Nash Bargaining: Risk Aversion and Impatience," Decision Analysis, INFORMS, vol. 9(1), pages 31-40, March.
    8. L. Robin Keller, 2008. "From the Editor..," Decision Analysis, INFORMS, vol. 5(1), pages 1-4, March.
    9. Logan, Douglas M., 1990. "5.4. Decision analysis in engineering-economic modeling," Energy, Elsevier, vol. 15(7), pages 677-696.
    10. J. Eric Bickel, 2006. "Some Determinants of Corporate Risk Aversion," Decision Analysis, INFORMS, vol. 3(4), pages 233-251, December.
    11. L. Robin Keller & Ali Abbas & J. Eric Bickel & Vicki M. Bier & David V. Budescu & John C. Butler & Enrico Diecidue & Robin L. Dillon-Merrill & Raimo P. Hämäläinen & Kenneth C. Lichtendahl & Jason R. W, 2012. "From the Editors ---Brainstorming, Multiplicative Utilities, Partial Information on Probabilities or Outcomes, and Regulatory Focus," Decision Analysis, INFORMS, vol. 9(4), pages 297-302, December.
    12. James E. Smith, 2004. "Risk Sharing, Fiduciary Duty, and Corporate Risk Attitudes," Decision Analysis, INFORMS, vol. 1(2), pages 114-127, June.
    13. David B. Brown & Melvyn Sim, 2009. "Satisficing Measures for Analysis of Risky Positions," Management Science, INFORMS, vol. 55(1), pages 71-84, January.
    14. J. Eric Bickel, 2008. "The Relationship Between Perfect and Imperfect Information in a Two-Action Risk-Sensitive Problem," Decision Analysis, INFORMS, vol. 5(3), pages 116-128, September.
    15. Botond Kőszegi & Matthew Rabin, 2006. "A Model of Reference-Dependent Preferences," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 121(4), pages 1133-1165.
    16. Epstein, Larry G. & Zin, Stanley E., 2001. "The independence axiom and asset returns," Journal of Empirical Finance, Elsevier, vol. 8(5), pages 537-572, December.
    17. Colson, Gérard, 1993. "Prenons-nous assez de risque dans les théories du risque?," L'Actualité Economique, Société Canadienne de Science Economique, vol. 69(1), pages 111-141, mars.
    18. Simone Cerreia‐Vioglio & David Dillenberger & Pietro Ortoleva, 2015. "Cautious Expected Utility and the Certainty Effect," Econometrica, Econometric Society, vol. 83, pages 693-728, March.
    19. Steffen Huck & Wieland Müller, 2012. "Allais for all: Revisiting the paradox in a large representative sample," Journal of Risk and Uncertainty, Springer, vol. 44(3), pages 261-293, June.
    20. Alan Brennan & Samer Kharroubi & Anthony O'Hagan & Jim Chilcott, 2007. "Calculating Partial Expected Value of Perfect Information via Monte Carlo Sampling Algorithms," Medical Decision Making, , vol. 27(4), pages 448-470, July.

    Corrections

    All material on this site has been provided by the respective publishers and authors. You can help correct errors and omissions. When requesting a correction, please mention this item's handle: RePEc:inm:ordeca:v:5:y:2008:i:1:p:5-9. See general information about how to correct material in RePEc.

    If you have authored this item and are not yet registered with RePEc, we encourage you to do it here. This allows to link your profile to this item. It also allows you to accept potential citations to this item that we are uncertain about.

    If CitEc recognized a bibliographic reference but did not link an item in RePEc to it, you can help with this form .

    If you know of missing items citing this one, you can help us creating those links by adding the relevant references in the same way as above, for each refering item. If you are a registered author of this item, you may also want to check the "citations" tab in your RePEc Author Service profile, as there may be some citations waiting for confirmation.

    For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: Chris Asher (email available below). General contact details of provider: https://edirc.repec.org/data/inforea.html .

    Please note that corrections may take a couple of weeks to filter through the various RePEc services.

    IDEAS is a RePEc service. RePEc uses bibliographic data supplied by the respective publishers.