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Intermediate Financial Theory, 3rd Edition by John B. Donaldson, Jean-Pierre Danthine

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Chapter 4

Measuring Risk and Risk Aversion

It has been argued that the desire for investors is to avoid risk; that is, the desire to smooth their consumption across states of nature and, therefore, to avoid variations in the value of their portfolio holdings, is a primary motivation for financial contracting. In this chapter restrictions are imposed on the form of the VNM expected utility representation which necessarily guarantees such behavior. The measures of relative risk aversion and absolute risk aversion are introduced. Limitations to the theory are also addressed.

Keywords

risk aversion; Jensen’s inequality; certainty equivalent; constant relative risk aversion (CRRA); constant absolute risk aversion (CARA); risk neutrality; first and second ...

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