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on Utility Models and Prospect Theories |
| By: | Massimo Guidolin (Federal Reserve Bank of St. Louis); Giovanna Nicodano (Department of Economics, University of Turin and Center for Research on Pensions and Welfare Policies, Turin) |
| Abstract: | Small capitalization stocks are known to have asymmetric risk across bull and bear markets. This paper investigates how variance risk affects international equity diversification by examining the portfolio choice of a power utility investor confronted with an asset menu that includes (but is not limited to) European and North American small equity portfolios. Stock returns are generated by a multivariate regime switching process that is able to account for both non-normality and predictability of stock returns. Non-normality matters for portfolio choice because the investor has a power utility function, implying a preference for positively skewed returns and aversion to kurtosis. We find that small cap portfolios command large optimal weights only when regime switching (and hence variance risk) is ignored. Otherwise a rational investor ought to hold a well-diversified portfolio. However, the availability of small caps substantially increases expected utility, in the order of riskless annualized gains of 3 percent and higher. These findings are robust to a number of modifications concerning the coefficient of relative risk aversion, the investment horizon, short-sale possibilities, and the exact structure of the asset menu. |
| Keywords: | strategic asset allocation, markov-switching, size effects, liquidity (variance) risk |
| Date: | 2005–02 |
| URL: | http://d.repec.org/n?u=RePEc:crp:wpaper:41&r=upt |
| By: | Kevin Roberts |
| Abstract: | For over a quarter of a century, the use of utility information based upon interpersonal comparisons has been seen as an escape route from the Arrow Impossibility Theorem. This paper critically examines this informational basis approach to social choice. Even with comparability of differences and levels, feasible social choice rules must be insensitive to a range of distributional issues. Also, the Pareto principle is not solely to blame for the inability to adopt rules combining utility and non-utility information: if the Pareto principle is not invoked then there is no way of combining utility and non-utility information in a ranking of states unless levels of utility are comparable; with level comparability, information can be combined only in restrictive ways and the notion of giving different independent weight to different considerations is ruled out. If informational bases are viewed as the restriction on information that is available, rather than a theoretical limit on information, then there exist methods to estimate richer informational structures and overcome these difficulties. |
| Keywords: | Social Choice, Informational Bases, Interpersonal Comparisons, Non-utility Information |
| JEL: | D63 D71 |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:oxf:wpaper:247&r=upt |
| By: | Philip Bond; David K. Musto; Bilge Yilmaz |
| Abstract: | Regulators express growing concern over “predatory lending,” which we take to mean lending that reduces the expected utility of borrowers. We present a rational model of consumer credit in which such lending is possible, and identify the circumstances in which it arises with and without competition. Predatory lending is associated with imperfect competition, highly collateralized loans, and poorly informed borrowers. Under most circumstances competition among lenders eliminates predatory lending. |
| Keywords: | Predatory lending |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedpwp:06-2&r=upt |
| By: | Eric J. Johnson (Columbia University); Simon Gächter (University of Nottingham, CESifo and IZA Bonn); Andreas Herrmann (University of St. Gallen) |
| Abstract: | Loss aversion, the fact that losses have a greater impact than gains, is a fundamental property of behavioral accounts of choice. In this paper, we suggest four possible characterizations of the relative impact of losses and gains: (1) It could be a constant, such as the much cited value of 2, as in losses have twice the impact of gains. (2) It could be a systematic individual difference, with some individuals more or less loss aversion, (3) it could be a property of the attribute, or (4) a property of the different processes used to construct selling and buying prices. We examine the behavior of a large sample of auto buyers using an experiment which allows us to measure loss aversion, at the individual level for several different attributes. A set of hierarchical linear models shows that to understand loss aversion, one must consider the process used to construct prices. Interestingly, we show that knowledge of the attribute lowers loss aversion and that age and attribute importance increases loss aversion. |
| Keywords: | loss aversion, consumer choice, reference-dependent preferences |
| JEL: | C90 M31 D11 |
| Date: | 2006–03 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp2015&r=upt |
| By: | Alan Beggs; Kathryn Graddy |
| Abstract: | This paper tests for reference dependence, using data from Impressionist and Contemporary Art auctions. We distinguish reference dependence based on "rule of thumb" learning from reference dependence based on "rational" learning. Furthermore, we distinguish pure reference dependence from effects due to loss aversion. Thus, we use actual market data to test essential characteristics of Kahneman and Tversky`s Prospect Theory. The main methodological innovations of this paper are firstly, that reference dependence can be identified separately from loss aversion. Secondly, we introduce a consistent non-linear estimator to deal with measurement errors problems involved in testing for loss aversion. In this dataset, we find strong reference dependence but no loss aversion. |
| Keywords: | Reference Dependence, Loss Aversion, Prospect Theory, Art, Auctions |
| JEL: | D81 D44 L82 |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:oxf:wpaper:228&r=upt |
| By: | Simon Luechinger (University of Zurich); Alois Stutzer (University of Zurich and IZA Bonn); Rainer Winkelmann (University of Zurich and IZA Bonn) |
| Abstract: | Sorting of people on the labor market not only assures the most productive use of valuable skills but also generates individual utility gains if people experience an optimal match between job characteristics and their preferences. Based on individual data on reported satisfaction with life it is possible to assess these latter gains from matching. We introduce a two-equation ordered probit model with endogenous switching and study self-selection into government and private sector jobs. We find considerable gains from matching amounting to an increase in the fraction of very satisfied workers from 53.8 to 58.8 percent relative to a hypothetical random allocation of workers to the two sectors. |
| Keywords: | matching, ordered probit, public sector employment, selection, switching regression, subjective well-being |
| JEL: | D60 I31 J24 J45 |
| Date: | 2006–03 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp2019&r=upt |
| By: | Junjian Miao (Department of Economics, Boston University) |
| Abstract: | This paper analyzes an agent's option exercise decision under uncertainty. The agent decides whether and when to do an irreversible activity. He is tempted by immediate grati¯cation and su®ers from self-control problems. This paper adopts the Gul and Pensendorfer self- control utility model. Unlike the time inconsistent hyperbolic discounting model, it provides an explanation of procrastination and preproperation based on time consistency. When applied to the investment and exit problems, it is shown that (i) if the project value is immediate, an investor may invest in negative NPV projects; (ii) if the production cost is immediate, a ¯rm may exit even if it makes positive net pro¯ts; and (iii) if both rewards and costs are immediate, an agent may simply follow the myopic rule which compares only the current period bene¯t and cost. |
| Keywords: | self-control, temptation, procrastination, preproperation, option value |
| JEL: | D81 D91 |
| Date: | 2005–07 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-007&r=upt |
| By: | Michela Cella |
| Abstract: | We study a model of informed principal with private values where the principal is risk neutral and the agent is risk averse. We show that the principal, regardless of her type, gains by not revealing her type to the agent through the contract offer. The equilibrium allocation transfers some ex-ante risk from one type of agent to the other. Despite the increase in the principal`s surplus, allocative efficiency does not necessarily improve. |
| Keywords: | Contract, Adverse Selection, Informed Principal, Risk Aversion |
| JEL: | C72 D23 D82 |
| Date: | 2005 |
| URL: | http://d.repec.org/n?u=RePEc:oxf:wpaper:234&r=upt |
| By: | Adrien Verdelhan (Department of Economics, Boston University) |
| Abstract: | This paper presents a fully rational general equilibrium model that produces a time- varying exchange rate risk premium and solves the uncovered interest rate parity (U.I.P) puzzle. In this two-country model, agents are characterized by slow-moving external habit preferences derived from Campbell & Cochrane (1999). Endowment shocks are i.i.d and real risk-free rates are time-varying. Agents can trade across countries, but when a unit is shipped, only a fraction of the good arrives to the foreign shore. The model gives a rationale for the U.I.P puzzle: the domestic investor receives a positive exchange rate risk premium when she is more risk-averse than her foreign counterpart. Times of high risk- aversion correspond to low interest rates. Thus, the domestic investor receives a positive risk premium when interest rates are lower at home than abroad. The model is both simulated and estimated. The simulation recovers the usual negative coefficient between exchange rate variations and interest rate differentials. When the iceberg-like trade cost is taken into account, the exchange rate variance produced is in line with its empirical counterpart. A nonlinear estimation of the model using consumption data leads to reasonable parameters when pricing the foreign excess returns of an American investor. |
| Keywords: | Exchange rate, Time-varying risk premium, Habits |
| JEL: | F31 G12 G15 |
| Date: | 2005–08 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-031&r=upt |
| By: | Ulf von Lilienfeld-Toal (Department of Economics, University of Frankfurt); Dilip Mookherjee (Department of Economics, Boston University) |
| Abstract: | Should the law restrict liability of defaulting borrowers? We abstract from possible benefits arising from limited rationality or risk-aversion of borrowers, contractual incompleteness, or lender moral hazard. We focus instead on general equilibrium implications of liability rules with moral hazard among borrowers with varying wealth. If lenders are on the short side of the market, weakening liability rules lower lender profits, may cause additional exclusion among the poor, but generate additional rents for wealthier borrowers. For certain changes in liability rules (such as a ban on bonded labor, or weakening bankruptcy rules below a wealth threshold) they also raise productivity among borrowers of intermediate wealth. Hence they can be interpreted as a form of efficiency-enhancing redistribution from lenders and poor borrowers to middle class borrowers. Our model provides a possible rationale for why weaker liability rules are observed in wealthier countries. |
| Date: | 2005–09 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2005-034&r=upt |
| By: | Kevin X. D. Huang; Zheng Liu; Qi Zhu |
| Abstract: | This paper studies the empirical relevance of temptation and self-control using household-level data from the Consumer Expenditure Survey. We estimate an infinite-horizon consumption-savings model that allows, but does not require, temptation and self-control in preferences. To help identify the presence of temptation, we exploit an implication of the theory that a tempted individual has a preference for commitment. In the presence of temptation, the cross-sectional distribution of the wealth-consumption ratio, in addition to that of consumption growth, becomes a determinant of the asset-pricing kernel, and the importance of this additional pricing factor depends on the strength of temptation. The estimates that we obtain provide statistical evidence supporting the presence of temptation. Based on our estimates, we explore some quantitative implications of this class of preferences on equity premium and on the welfare cost of business cycles. |
| Date: | 2006 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedmsr:367&r=upt |
| By: | Christian Grund; Dirk Sliwka (University of Cologne and IZA Bonn) |
| Abstract: | A main prediction of agency theory is the well known risk-incentive trade-off. Incentive contracts should be found in environments with little uncertainty and for agents with low degrees of risk aversion. There is an ongoing debate in the literature about the first trade-off. Due to lack of data, there has so far been hardly any empirical evidence about the second. Making use of a unique representative data set, we find clear evidence that risk aversion has a highly significant and substantial negative impact on the probability that an employee’s pay is performance contingent. |
| Keywords: | risk, incentives, agency theory, risk aversion, performance appraisal, pay for performance, GSOEP |
| JEL: | J33 M52 D80 |
| Date: | 2006–03 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp2012&r=upt |