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Risk and Probability Premiums for Cara Utility Function

Author

Listed:
  • Babcock, Bruce A.
  • Choi, E. Kwan
  • Feinerman, Eli

Abstract

The risk premium and the probability premium are used to determine appro- priate coefficients of absolute risk aversion under CARA utility. A defensible range of risk-aversion coefficients is defined by the coefficients that correspond to risk premiums falling between 1 and 99% of the amount at risk or to probability premiums falling between .005 and .49 for a lottery that pays or loses a given sum. The consequences of ignoring risk premiums when selecting risk-aversion coefficients for representative decision makers are illustrated by calculation of the implied risk premium associated with the levels of absolute risk aversion assumed in six selected studies.
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Suggested Citation

  • Babcock, Bruce A. & Choi, E. Kwan & Feinerman, Eli, 1993. "Risk and Probability Premiums for Cara Utility Function," Staff General Research Papers Archive 596, Iowa State University, Department of Economics.
    • Handle: RePEc:isu:genres:596
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