Risk Aversion

Abstract

The concept of risk aversion is linked with the idea of a fair bet. A fair bet is an uncertain prospect whose expected yield is zero. A person is risk averse if he never accepts a fair bet. A person is called a risk lover if he always accepts a fair bet. If a person is always indifferent between accepting a fair bet and rejecting it, he is called a risk neutral person. Note, one may not belong to any of these three categories. Consider the following two cases. A coin is tossed. In the first case, if head comes up the gambler receives $1. If tail comes up then he will have to pay $1. This is a fair bet with zero expected return. In the second case, the sum is raised to $1000. It is not unusual for a person to play the first bet and refuse to play the second bet. He is a risk lover for small bets and a risk averse person for large bets. We shall discuss these cases later on.