A certainty equivalent is a risk-free payment accepted instead of a higher return with risk. It varies from person to person, and can be seen in game shows and investments. Risk premiums can make investments more attractive.
A certainty equivalent is a risk-free payment that someone will accept rather than bet on a return that may be higher, but carries risk. The amount of the certainty equivalent varies from person to person. Someone who is risk averse may accept one that is smaller than the potential reward involved in the gamble, while others may demand a higher certainty equivalent to consider the riskier endeavor worth abandoning.
A common example of the certainty equivalent can be seen in game shows. Contestants on game shows are often offered a choice: they can take a sum of money and walk out, or they can move on to the next phase of the show to compete for more money. The program calculates this sum carefully. Risk-averse contestants can take payment and walk away, glad to walk away with some money instead of none. Others may decline the offer and move on to the next phase and the chance to go home with more substantial profits.
In the investment community, certainty equivalents can be important. A start-up company, for example, wants to attract investors who are willing to bet on its shares for a chance at a big reward. They should consider risk-free alternatives that may be available when they are working to attract investors so that they can think about the equivalent of certainty for individual investors. If the initial stock price is set too high, investors won’t be interested.
The highest payment can be an uncertain payment, especially in the financial world. Similarly, some game shows are structured in a way that obscures the full potential of the reward, and the amount varies. For example, contestants can spin a wheel to see how much money they win. This may affect the equivalent certainty for individuals because they may understandably be concerned about the unknown nature of the risk.
Certainty equivalents arise in the context of determining a risk premium for a given investment or other activity. The risk premium is determined by subtracting the risk-free payoff from the expected return on the riskier investment. Creating a risk premium can make an investment or similar activity more attractive, because people are willing to take the risk with the highest reward. This tactic is often used in settings such as game shows to build tension and create an incentive to continue.
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