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What is exponential utility?

Exponential utility

It is a class of utility function that's used in many financial investment decisions. An exponential utility function has just one adjustable numerical parameter, called the risk tolerance, and there are straightforward ways to discover an appropriate value of this parameter for a company or individual.

Where have you heard about exponential utility?

If you're a mathematician, a risk analyst or an experienced investor you may be familiar with the exponential utility function. It's not widely known outside these circles, nor is it the subject of much business comment in the print and broadcast media.

What you need to know about exponential utility.

An exponential utility function has the following form:

U(x) = 1 - e-x/R

Here, x is a monetary value (a payoff or cost), U(x) is the utility of this value, and R>0 is the risk tolerance - measuring how much risk the decision maker will accept. The bigger the value of R, the less risk averse the decision maker is.

The advantage of using an exponential utility function is that it's relatively easy to assess - which has made it a popular method. The disadvantage is that exponential utility functions don't capture all types of attitudes towards risk.

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