We consider uncertainty modelled here by a set Ω, containing issues or scenarios. We present
some classical measures attached to a scalar prospect (random variable) X : Ω → ℝ. Here, X
represents a gain, a profit, a position, the value of a portfolio, etc., in a word a prospect while −X
represents a loss.
When focusing on situations of risk, we shall suppose that Ω carries a probability ℙ (defined on
a σ-field ℱ, so that (Ω,ℱ, ℙ) is a probability space). The expectation under probability ℙ is
denoted by 𝔼.
1 Value at Risk
The Value at Risk of a prospect X at level λ ∈]0, 1[ is
(1)
Intuitively, saying that the VaR5% of a portfolio is 100 means that the loss −X will be larger than
100 with probability at most 5%. However, VaR5% does not inform on the size of the
loss.
1.1 Value at Risk of a log-normal prospect
Question 1Compute the Value at Risk at different levels (1%, 5%, 10%) of alog-normal prospect. Draw the empirical cumulated distribution of a log-normal prospect.
A prospect X is said to be log-normal if X > 0 and log X ∼𝒩(μ,σ2).
Figure 1: Empirical cumulated distribution of a Log-Normal prospect X, such that log X ∼𝒩(μ,σ2) with μ = −1 and σ2 = 0.09. We observe that VaR10%(X) ≈−0.33.
stacksize(2*10^8);
N=10^8; // number of simulations
mean=-1;
variance=0.09;
Y=grand(1,N,'nor',mean,variance) ; // simulation of a Normal r.v.
Z=sort(exp(Y));
// decreasing sort of the simulated realizations of a Log-Normal r.v.
values= Z($:-1:1) // increasing sorting
// the VaR is -quantile
lambda=0.01;
quantile=values(int(lambda*N));
disp('VaR_('+string(lambda) +')(Z)='+string(-quantile))
Corporate bonds are sold at 95 $ and return 100 $ except in 2 % of cases where they lose all
value. The prospect Xi provided is thus Xi = 100𝜀i− 95 ∈{5,−95}, where ℙ(𝜀i = 1) = 0.98 and
ℙ(𝜀i = 0) = 0.02.
First, let us consider a fully concentrated portfolio C = 100X1, consisting of 100 units of the
first bond. Second, let us consider a fully diversified portfolio D = 2 ∑i=150Xi, consisting of
2 units of each bond. The 𝜀1, …, 𝜀50 are supposed to be independent.
Question 2Using the fact that VaR5%(𝜀1) = −1, and positive homogeneity andtranslation-invariance of VaR5%, compute VaR5%(X1), then VaR5%(C). EstimateVaR5%(D) by simulation. Conclude that withdrawing up to 500$ from the fully concentratedportfolio C makes it acceptable, while you need to add a capital of at least 100$ to the fullydiversified portfolio D to make this latter acceptable.
Figure 2: Empirical cumulated distribution of the diversified portfolio
N=1000;
bb=50; // 50 independent couples of bonds
A=rand(bb,N);
EPS= 0.5 * ( 1 + sign(A-0.02) ) ;
// an array where each column contains
// bb independent realizations of the r.v. epsilon
DD=sum( 2 * (100 * EPS - 95 ) , 'r') ;
// N realizations of the diversified portfolio D
// xset('window',12) ; xbasc(); histplot(10,DD);
// xtitle('Empirical histogram of the diversified portfolio D')
SDD=sort(DD);
values= SDD($:-1:1);
lambda=0.05;
xset('window',13) ; xbasc(); plot2d(values,linspace(0,1,N));
plot2d(values,lambda*ones(values),style=5);
xtitle('Empirical cumulated distribution ...
of the diversified portfolio DD')
VaR=-values(int(lambda*N));
disp('The Value at Risk of the diversified portfolio D is ')
disp('VaR_('+string(lambda) +')(DD)='+string(VaR))
2 Expected utility theory
The lottery describes a hazard situation where
the outcome w1 may appear with probability p1,
…
wn with probability pn,
where all probabilities are greater than or equal to zero and sum up to one (100% chance).
Suppose that the outcomes are scalar. Let us be given a utility function
. The value of the lottery is the expectation of the utilities :
In a choice situation between two lotteries, the expected utility maximizer will select the one with
the highest EU.
2.1 Expected utility of a simple lottery
3 $
50%
-1 $50%
Question 3Compute the expected utility of the lotteryfor theutility function.
function v=EU(lottery,utility)
values=utility(lottery(1,:));
probabilities=lottery(2,:);
v=sum(probabilities.*values) ;
endfunction
Question 4Which of the two above lotteries do you personnaly prefer? Load the function EUfollowing Question3. Compute the expected utility of the lotteriesandfor different utility functions:
CARA, A > 0;
CRRA, γ > 0, γ ⁄= 1, w > 0.
For each utility function, tell which lottery is prefered to the other one, and explain the reasons of yourchoice.
Question 5Same questions as in Question5for the lotteriesand.
Question 6What do you conclude from your own preferences, compared to the expectedutility evaluations of Questions4and5? What is the relation with Allais’ paradox?
2.3 Bank questionnaire
In a bank questionnaire, the customer answers a series of questions ranging from 8 to 13. In
question k, he is asked which lottery he prefers between a certain lottery LOTTERY_C(k) and a
50%-50% risky lottery LOTTERY_R(k).
Question 7Load the function EU following Question3. Test wether lottery LOTTERY_C(k)is prefered to the 50%-50% risky lottery LOTTERY_R(k) for k = 8,…, 13, for the CARA utilityfunctions, A > 0. Compute the Arrow-Pratt coefficient of absolute riskaversion. Select a proper range of values for the parameterA. How do youexplain what you observe when the parameterA varies?
TEST_CARA=[];
for k=8:13
lottery_C=LOTTERY_C(k);
lottery_R=LOTTERY_R(k);
v_C=[];
v_R=[];
rangeA=10^(-4)*[0.3:0.5:4];
for A=rangeA
function u=CARA(w)
u=-%e^{-A*w};
endfunction
v_C=[v_C,EU(lottery_C,CARA)];
v_R=[v_R,EU(lottery_R,CARA)];
end
TEST_CARA=[TEST_CARA;v_C-v_R];
end
Question 8Same question for the CRRA utility functions, γ > 0, γ ⁄= 1,w > 0. Compute the Arrow-Pratt coefficient of relative risk aversion.How do you explain what you observe when the parameterγ varies? Compare your resultswith the one in the document Lettre à S.by the economist Laurent Denant-Boemont. Do youagree with all his comments?
TEST_CRRA=[];
for k=8:13
lottery_C=LOTTERY_C(k);
lottery_R=LOTTERY_R(k);
v_C=[];
v_R=[];
// for gama=[0.5 1.5] //
for gama=0.05:0.2:2 // to avoid gama=1
function u=CRRA(w)
u= w^{1-gama}/(1-gama) ;
endfunction
v_C=[v_C,EU(lottery_C,CRRA)];
v_R=[v_R,EU(lottery_R,CRRA)];
end
TEST_CRRA=[TEST_CRRA;v_C-v_R];
end
TEST_CRRA
Question 9Same question for the power-expo utility functions,
1 > γ > 0, w > 0.
TEST_SAHA=[];
for k=8:13
lottery_C=LOTTERY_C(k);
lottery_R=LOTTERY_R(k);
v_C=[];
v_R=[];
A=0.08;
// for gama=0.8
for gama=0.05:0.2:1
function u=SAHA(w)
u=(1-%e^{-A*w^(1-gama)})/A;
endfunction
v_C=[v_C,EU(lottery_C,SAHA)];
v_R=[v_R,EU(lottery_R,SAHA)];
end
Suppose that you are a decision-maker who evaluates any prospect X by
(2)
is a CRRA (constant relative risk aversion) utility function. The parameter γ > 0 is the relativerisk aversion parameter.
Consider the situation where you face the risk of gaining or losing a share 𝜃 of your
wealth w0 with equal probability. The relative risk premium πγ(𝜃) is implicitely defined
by
(3)
where X takes values 1 − 𝜃 and 1 + 𝜃 with equal probability 1∕2. The relative risk premium πγ(𝜃)
is the share of your wealth that you are ready to pay to escape this risk.
Question 10Give the formula for πγ(𝜃). For each 𝜃 =5 %, 15 %, 25 %, draw the curvegiving the relative risk aversion parameter γ as a function of the relative risk premium. Fillin the second column of Table2.4with your relative risk premium and compute your relativerisk aversion. Comment on what you observe.
//
theta=0.25 ;
gama=0.5:0.9:40; // avoid the value gama=1
premium=1-(0.5*(1-theta).^{1-gama}+...
0.5*(1+theta).^{1-gama}).^{1 ./(1-gama)};
xset('window',20) ; xbasc(); plot2d(premium,gama);
xtitle('Relative risk aversion parameter as function of ...
relative risk premium when theta= '+string(theta))
Suppose that the prospect X takes a finite number of values
(4)
with corresponding probabilities (nonnegative and summing up to one)
(5)
The evaluation of a prospect with null anchor x0 = 0 is given by
(6)
where U is a strictly increasing function such that U(0) = 0. When the anchor x0 is not necessarily
zero, we evaluate the prospect by V (X − x0). The weighting functions for gains and losses are
given by
(7)
where w+ and w− are increasing functions satisfying w+(0) = w−(0) = 0 and w+(1) = w−(1) = 1.
In (Tversky and Kahneman, 1992), one finds
Question 11Same questions as in §2.2, but evaluating lotteries by CPT, with either zeroanchor, or a positive one that you will choose.
anchor=0;
v=CPT_eval(lottery_1Z,anchor)
3.4 Bank questionnaire
Question 12Same questions as in §3.4, but evaluating lotteries by CPT, with either zeroanchor, or the value of the certain lottery.
v_C=[];
v_R=[];
for k=8:13
lottery_C=LOTTERY_C(k);
lottery_R=LOTTERY_R(k);
//
anchor=0;
anchor=lottery_C(1,:);
//
v_C=[v_C,CPT_eval(lottery_C,anchor)];
v_R=[v_R,CPT_eval(lottery_R,anchor)];
end
TEST_CPT=v_C-v_R
3.5 Relative risk aversion
Let us consider the problem in Sect. 2. Suppose that you face the risk of gaining or losing a share
𝜃 of your wealth x0 with equal probability. The relative risk premium πCPT(𝜃) is the share of your
wealth that you are ready to pay to escape this risk. Expressing indifference between this risk and
the certain prospect x01 − 𝜃 gives:
(12)
Notice that (8) with α = β implies that the evaluation of a prospect with respect to an anchor
is invariant with respect to a positive scaling factor (of both the prospect and the anchor). We thus
write the above equation with x0 = 1, to obtain:
The compte d’épargne MMmax was launched in November 2003 by Mutuelles du Mans. This
financial product returns 2.5 % for sure every year and, when lucky, additional 5 %, 10 % or
20 % (see details in the Scilab code below). We want to test its success to the public by
comparison with a safe product returning a fixed rate every year (anchor).
Question 13The values for MMmax are given below. Show that its mean return is slightlymore than 3.5% Draw the evaluation of this product as function of the anchor for an investorevaluating prospects according to Cumulative Prospect Theory (CPT investor, in short).Observe that any safe product with return more than 3.3% is prefered to the risky MMmax.Conclude that a CPT investor is less encline to invest in MMmax than in safe product,compared to a risk-neutral investor.
//
lotery_MMmax=[1025 1075 1125 1225 ; // return for 1000 euros
0.81 0.171 0.0171 0.0019] ; // probabilities
// Compte d'\'epargne MMmax launched in November 2003 by
// Mutuelles du Mans
disp("=======================================");
disp("This is the MMmax lotery for an investment of 1000 euros")
disp(lotery_MMmax)
for anchor=anchors
CPT_Values=[CPT_Values,CPT_eval(lotery_MMmax,anchor)];
RN_Values=[RN_Values,RN_eval(lotery_MMmax,anchor)];
end
xset('window',30)
xbasc(); plot2d(anchors_percent,...
[ 0*ones(anchors) ; CPT_Values ; RN_Values ]' );
xtitle('CPT and RN evaluation of MMmax ...
as function of the anchor','anchor (%)','')
legends([ 'Cumulative Prospect Theory (CPT)'; 'Risk Neutral (RN)' ] ,...
[2,3], 'ur' );
xstring(2.95,-1.5,["RN and CPT prefer" ; "MMax to safe"],0,0)
xstring(3.3,1.5,["RN prefers MMax to safe but not CPT"],30,1)
xstring(3.55,0.5,["RN and CPT prefer" ; "safe to MMax"],0,0)
anchor=1033.37;
disp("for annual safe return anchor of " +string(scaling(anchor)) +"%, ...
the CPT evaluation is " +string(CPT_eval(lotery_MMmax,anchor)))
anchor=1033.38;
disp("for annual safe return anchor of " +string(scaling(anchor)) +"%, ...
the CPT evaluation is " +string(CPT_eval(lotery_MMmax,anchor)))
//
Figure 4: Evaluation of MMmax as function of the anchor. When the evaluation is positive,
an investor prefers MMmax to the safe return in abscisse. A risk neutral investor prefers
MMmax to any safe return between 3.338% and 3.564%, while this is the contrary for a CPT
investor.
References
Rudiger Frey and Alexander J. McNeil. Var and expected shortfall in portfolios of
dependent credit risks: Conceptual and practical insights. Journal of Banking and Finance,
26:1317–1334, 2002.
C. Gollier. The Economics of Risk and Time. MIT Press, Cambridge, 2001.
Daniel Kahneman and Amos Tversky. Prospect theory: An analysis of decision under
risk. Econometrica, 47(2):263–292, 1979.
Marie Pfiffelmann and Patrick Roger. Les comptes d’épargne associés à des loteries:
approche comportementale et étude de cas. Banque & Marchés, septembre 2005.
Amos Tversky and Daniel Kahneman. Advances in prospect theory: Cumulative
representation of uncertainty. Journal of Risk and Uncertainty, 5(4):297–323, October
1992.