Utility Functions

Abstract

This article is a self-contained survey of utility functions and some of their applications. Throughout the paper the theory is illustrated by three examples: exponential utility functions, power utility functions of the first kind (such as quadratic utility functions), and power utility functions of the second kind (such as the logarithmic utility function). The postulate of equivalent expected utility can be used to replace a random gain by a fixed amount and to determine a fair premium for claims to be insured, even if the insurer’s wealth without the new contract is a random variable itself. Then n companies (or economic agents) with random wealth are considered. They are interested in exchanging wealth to improve their expected utility. The family of Pareto optimal risk exchanges is characterized by the theorem of Borch. Two specific solutions are proposed. The first, believed to be new, is based on the synergy potential; this is the largest amount that can be withdrawn from the system without hurting any company in terms of expected utility. The second is the economic equilibrium originally proposed by Borch. As by-products, the option-pricing formula of Black-Scholes can be derived and the Esscher method of option pricing can be explained.