Risk aversion

Let u(x) denote a decision maker’s utility function on amounts of money. Risk aversion is equivalent to the strict concavity of u(x), implying decreasing marginal utility of money.

For a risk averter the certainty equivalent of a risky prospect, which is the amount of money for which the individual is indifferent between the risky prospect and the certain amount, is strictly less than the mathematical expectation of the outcomes of the risky prospect. The degree of (absolute) risk aversion can be measured by means of the Arrow-Pratt coefficient of risk aversion, which is suitable for both comparisons across individuals and comparisons across wealth levels of a single decision maker. Risk aversion of investors belongs to the crucial assumptions of numerous models in finance theory (e.g., the Capital Asset Pricing Model, CAPM).

See also: preferences, risk, risk attitude, utility

Literature: Hirshleifer & Riley (1992), Mas-Colell, Whinston & Green (1995), Sharpe & Bailey (1995)

Entry by: Frank Vossmann

November 17, 1997
Direct questions and comments to: Glossary master