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Risk-Adjusted Values, Timing of Uncertainty Resolution, and the Measurement of Project Worth

Published online by Cambridge University Press:  06 April 2009

Richard H. Bernhard
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Extract

In the standard setting in which an individual or firm has preferences for probabilistic monetary outcomes that satisfy the Neumann-Morgenstern [10] assumptions of “rational behavior” and has an exponential utility function for money, a popular index for evaluating any proposed single-period probabilistic project is its “risk-adjusted value” (RAV), i.e., its certainty equivalent, the certain amount of money that has the same utility as the expected utility for the project. Since the exponential function is completely characterized by just a single parameter, its risk aversion level, in comparing mutually exclusive projects one can simply plot their RAVs or their expected utilities as a function of this parameter and then, for any given value or range of values of the parameter, read off which project is best, i.e., has the highest RAV or, equivalently, the highest expected utility. (See, e.g., [7], p. 203 or [2].)

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , Volume 19 , Issue 1 , March 1984 , pp. 83 - 99
Copyright
Copyright © School of Business Administration, University of Washington 1984

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References

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