Question

Assuming a company has a constant risk aversion utility function (ie exponential), describe how you would estimate that company’s risk tolerance by observing the percentage share they take in joint projects.

Answer 1

Risk aversion of a country explains the risk in uncertainty of an industry. Risk aversion investors put their money in portfolio manner; like different securities. They invested in low interest rate. Through investing different securities the expected utility function are not uniquely defined.

Arrow-Pratt method of absolute risk aversion used under this condition. It is also known as coefficient of absolute risk aversion.

A(c) = u''(c)u'(c)

Among this, hyperbolic absolute risk aversion method is most probably used. It is the constant relative risk aversion. It is measured using the given below equation;

A(c) = u''(c)u'(c) = 1ac+b

Using differential equation;

u(c) = (c-Cs1-R1-R

Where, R= 1/α, Cs = -b/ α. When α=0, it is constant risk aversion.

Here the company tried to increase the risk aversion.

∂A(c)∂c = u'cu(c)-[u(c)]2[u'c]2

The increasing risk aversion shows u”’(c) > 0.