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Utility function

A

ALEX_AK

Member
From the Sweeting textbook,
Utility function combines measures of risk and return based on a given level of wealth into a single measure of utility.

There are 3 components here,
1) measures of risk and return
2) wealth
3) utility

In the common utility functions, I see W and alpha. May I know if alpha is the measure of risk and return? Any examples of what can this measure be based on or how it can be calculated?

The utility functions seem to be using alpha * W. Why is this so?
 
Alpha is a measure of risk aversion:
>0 for risk aversion
=0 for risk-neutrality
<0 for risk-seeking

It is being used to "weight" the wealth. If I have wealth of £1m and am risk averse with alpha=10, that is similar to someone who has £10m and is less risk-averse with alpha=1.

Calculating alpha is difficult as it relies on understanding how individuals behave when presented with financial decisions (behavioural economics).
 
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