Alternative Measures for Modeling Risk and Expected Utility Theory (Risk Adjustment, Measurement and Attitude)

Akin Seber


In this paper, we propose alternative measures for modeling risk to be used in Expected Return (ER) calculations instead of “Utility” of Expected Utility Theory (EUT). These new measures are based on the idea that: First, there is a need to make a Risk-Adjustment to make the risky-alternative comparable with the risk-free alternative. Second, the new measures can be more in congruence with actual risk attitude existing in the market. This is possible by making the Risk-Measurement to be included in the probability function and the expected return to be based on the market portfolio on the Capital Market Line (CML) tangent to the Markowitz Bullet as defined in CAPM of finance theory. Finaly, these new measures may also make it possible to include Risk-Attitude in the “Probability” or “Returns” functions and there may no longer be need for a “Utility” function. The two measures introduced in the paper can be used with certain advantages as a substitute for expected  utility theory of economics, game theory and decision theory in predicting choice behavior under risk, and in a more correct financial derivatives pricing using binomial models of finance.

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International Journal of Economics and Finance  ISSN  1916-971X (Print) ISSN  1916-9728 (Online)

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