
The Theory of Risk and Risk Aversion
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Again this definition for φ(x, h) holds for all values for h. For small h, Arrow and Pratt
use a quadratic Taylor Series approximation to u(x + h) and u(x − h) and show that the
probability premium is approximately given by:
As with the risk premium, the form of this result is that the decision maker’s reaction to
risk, φ(x, h), is proportional to the product of the strength or intensity of risk aversion
A
u
(x), and the size of the risk, in this case measured by h.
3.4.3 A-P Global Risk Aversion
The local and approximate findings discussed in Section 3.4.1 lend considerable intui-
tive appeal to A
u
(x) as a ...