One Theory For Two Risk Premia
Generally, in the standard presentation of the expected utility model, the risk premium represents how much a risk-averse decision maker is ready to pay to have a risk eliminated. Here, however, we introduce a different risk premium: how much should a risk (which could be the return on a financial asset) yield to be acceptable to a risk-averse decision maker. Although our risk premium is derived from the Pratt bid price, it should not be confused with it: the Pratt bid price represents the monetary compensation of a risk. The standard risk premium refers to risk-avoidance; our risk premium, however, refers to risk-taking. We then reanalyse the main results concerning risk aversion under expected utility using this risk premium tool and deduce its main properties.
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- Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
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