Determining the Risk Tolerance

The risk tolerance determines the curvature of the exponential utility function. When the risk tolerance is positive, the utility function is concave, or “hill-like.” Risk-averse decision makers have positive risk tolerances. Conversely, when the risk tolerance is negative, the utility function is convex, or “bowl-like.” Risk-seeking decision makers have negative risk tolerances. Finally, when the risk tolerance is infinity, the utility function is a straight line. Risk-neutral decision makers have straight-line utility functions.9

To determine a decision maker’s risk tolerance, it is important to utilize the concept of the certainty equivalent for an alternative with uncertain outcomes. The certainty equivalent ...

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