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Parametric Characterizations of Risk Aversion and Prudence

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  • Lajeri, Fatma
  • Nielsen, Lars Tyge

Abstract

We show that in order to determine whether one decision-maker is more risk averse than another, it is sufficient to consider their attitudes towards a given two-parameter family of risks. When all risks belong to this family, useful comparisons of risk aversion can be made even in situations of ‘background risk’. Since expected utility becomes a function of mean and standard deviation, risk aversion can be measured by the marginal rate of substitution between mean and standard deviation. A utility function exhibits decreasing risk aversion if, and only if, this slope is a decreasing function of the mean. Second, we use the concept of prudence to solve a long-standing problem in mean-variance analysis: what is the economic interpretation of the concavity of a utility function which is a function of mean and variance? We show that in the case of normal distributions, utility is concave as a function of variance and mean if, and only if, it exhibits decreasing prudence.

Suggested Citation

  • Lajeri, Fatma & Nielsen, Lars Tyge, 1997. "Parametric Characterizations of Risk Aversion and Prudence," CEPR Discussion Papers 1650, C.E.P.R. Discussion Papers.
    • Handle: RePEc:cpr:ceprdp:1650
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    Keywords

    Prudence; Risk Aversion;

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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