A Shortcut to Certainty Equivalent Discounts Charles J.

Higgins, PhD

In finance the expected value of a gamble is often not the value found for a market price. Instead the price often reflects the certainty equivalent to the expected utility of a gamble (see Arrow, Debreu, von Neumann, and Morgenstern). Here typically: 1) EV ProbiVi where EV is the expected value and is the sum of the probabilities times the value of each outcome, and whereas: 2) EU ProbiUi where EU is the expected utility and is the sum of the probabilities times the utility of each outcome. A well behaved and often empirically observed utility function is: 3) U(W) = log(W). It is well behaved (in contrast to say W1/2) in that the magnitude of scale of W does differ relatively to the utility of wealth (whereas W1/2 does not). The certainty equivalent is the value which has the same utility as does the expected utility. Here if U(W) equals log(W) then:

4) WCE = exp(EU) = exp( ProbiU[Wi]) = exp( Probilog[Wi]) where WCE is the value of the certainty equivalent. Consider the following gambles with equal probabilities of gain and loss of , computed standard deviations, certainty equivalents using exp and log functions, and subsequent discounts from the expected value: Out 1 Out 2 A B C 60 53 75 40 47 25 10 3 25 EV 50 50 50 Std. Dev. 10 3 25 CE Discount

48.99 1.01 49.91 .09

43.30 6.70

At this point a familiarity with log and exp functions and the ability compute or program becomes requisite and likewise tedious. However an approximation for the discount can be calculated from: 5) D = K(/K)2/2

where D is the discount from the expected value to the certainty equivalent for logarithmic utility functions of equal probability of a gain or a loss, K is the expected value, and /K is proportional amount of a gain or a loss. With simplification, the approximate discount can be computed from: 6) D = 2/2K.