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Interpretation of the risk tolerance coefficient in terms of maximum acceptable loss

Author: Delquié, Philippe INSEAD Area: Decision SciencesIn: Decision Analysis, vol. 5, no. 1, March 2008 Language: EnglishDescription: p. 5-9.Type of document: INSEAD ArticleNote: Please ask us for this itemAbstract: Users (or would-be users) of exponential expected utility often seek a concrete, intuitive meaning for the risk tolerance coefficient (RT) that they can grasp and explain to others easily. This paper shows an interpretation of RT as the maximum loss the decision maker is willing to be exposed to at a stated probability level, regardless of the upside potential. As an example, if you are facing a portfolio of projects having a 1 in 20 chance of total loss and you indicate that L is the maximum loss you would tolerate, then your risk tolerance is L/3. Other such examples, which may be better suited to other situations, are presented. In some contexts, this interpretation may be congruent with the way individuals naturally think about their risk taking propensity, for example, as willingness to be exposed to losses or as in Value-at-Risk. This interpretation can also be helpful in determining whether assuming exponential utility is adequate for the situation being analyzed, and in eliciting the value of RT. The merits of this approach for thinking about RT are discussed
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Users (or would-be users) of exponential expected utility often seek a concrete, intuitive meaning for the risk tolerance coefficient (RT) that they can grasp and explain to others easily. This paper shows an interpretation of RT as the maximum loss the decision maker is willing to be exposed to at a stated probability level, regardless of the upside potential. As an example, if you are facing a portfolio of projects having a 1 in 20 chance of total loss and you indicate that L is the maximum loss you would tolerate, then your risk tolerance is L/3. Other such examples, which may be better suited to other situations, are presented. In some contexts, this interpretation may be congruent with the way individuals naturally think about their risk taking propensity, for example, as willingness to be exposed to losses or as in Value-at-Risk. This interpretation can also be helpful in determining whether assuming exponential utility is adequate for the situation being analyzed, and in eliciting the value of RT. The merits of this approach for thinking about RT are discussed

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