Working paper

Downside Risk Aversion vs Decreasing Absolute Risk Aversion: An Intuitive Exposition

James K. Hammitt

Abstract

Downside risk aversion (downside RA) and decreasing absolute risk aversion (DARA) are different concepts that describe preferences for which the harm from bearing risk is lessened by an increase in wealth. This note presents some intuitive explanations of the difference between the two concepts using simple lotteries and graphical analysis. All risk-averse utility functions exhibit downside risk aversion, except those that exhibit sufficiently strong increasing absolute risk aversion (IARA). In a sense, downside RA is to be expected: adding downside risk to a baseline lottery is analogous to increasing risk while adding upside risk is analogous to decreasing risk. The difference between the two concepts can be attributed to the use of different measures of the harm from risk bearing: downside RA measures harm using the utility premium and DARA measures harm using the risk premium. The two premia can change at different rates and even in different directions as wealth increases.

Keywords

risk aversion; prudence; risk apportionment; utility premium;

Reference

James K. Hammitt, Downside Risk Aversion vs Decreasing Absolute Risk Aversion: An Intuitive Exposition, TSE Working Paper, n. 22-1359, September 2022.

See also

Published in

TSE Working Paper, n. 22-1359, September 2022