Microsoft PowerPoint - PoF.ppt

Expected utility and mean-variance criterionƒ 52

The mean-variance criterion used in the Markowitz model can be reconciled with the expected utility approach in either of two ways

ƒ

using a

quadratic utility function

, or

ƒ

assuming

normal returns.

ƒ

Quadratic utility function

ƒ

Utility reaches a maximum at some

wealth level and then declines.

ƒ

As your wealth level increases,

your willingness to take on risk

decreases.

ƒ

Normal returns

ƒ

Recall that empirical results reve

al that returns aren’t normal

distributed!

Single-period random cash

flows: Utility theory