
on Utility Models and Prospect Theories 
By:  Alexander Harin (MODERN UNIVERSITY FOR THE HUMANITIES  Modern University for the Humanities  [Modern University for the Humanities]) 
Abstract:  A man is a key subject of economics. “A man is irrational”  this opinion can be made from Allais paradox, risk aversion and other wellknown fundamental problems. For a long time, this opinion was a barrier to proper solution of these problems and the development of the economics. A radically new way is proposed to solve them and remove this barrier. The way is the generalization of a breach of a term of contract. 
Keywords:  contract; business; bank; trade; industry; development; risk; “ideal” economics; investment; choice 
Date:  2006–08–10 
URL:  http://d.repec.org/n?u=RePEc:hal:papers:halshs00089118_v1&r=upt 
By:  Günter Franke (Department of Economics, University of Konstanz); Richard C. Stapleton (University of Manchester and University of Melbourne); Marti G. Subrahmanyam (Stern School of Business, New York University) 
Abstract:  We present a necessary and sufficient condition on an agent’s utility function for a simple mean preserving spread in an independent background risk to increase the agent’s risk aversion (incremental risk vulnerability). Gollier and Pratt (1996) have shown that declining and convex risk aversion as well as standard risk aversion are sufficient for risk vulnerability. We show that these conditions are also sufficient for incremental risk vulnerability. In addition, we present sufficient conditions for a restricted set of stochastic increases in an independent background risk to increase risk aversion. 
Date:  2005–09–23 
URL:  http://d.repec.org/n?u=RePEc:knz:cofedp:0508&r=upt 
By:  Günter Franke (Department of Economics, University of Konstanz); Harris Schlesinger (University of Alabama); Richard C. Stapleton (University of Manchester and University of Melbourne) 
Abstract:  Although there has been much attention in recent years on the effects of additive background risks, the same is not true for its multiplicative counterpart. We consider random wealth of the multiplicative form xy, where x and y are statistically independent random variables. We assume that x is endogenous to the economic agent, but that y is an exogenous and nontradable background risk, which represents a type of market incompleteness. Our main focus is on how the presence of the multiplicative background risk y affects risktaking behavior for decisions on the choice of x. We characterize conditions on preferences that lead to more cautious behavior. 
Keywords:  multiplicative risks, background risk, incomplete markets, standard risk aversion, affiliated utility function, multiplicative risk vulnerability 
JEL:  D81 
Date:  2005–05 
URL:  http://d.repec.org/n?u=RePEc:knz:cofedp:0305&r=upt 
By:  Hélène Hamisultane (EconomiX  [CNRS : UMR7166]  [Université de Paris X  Nanterre]) 
Abstract:  Since the underlying of the weather derivatives is not a traded asset, these contracts cannot be evaluated by the traditional financial theory. Cao and Wei (2004) price them by using the consumptionbased asset pricing of Lucas (1978) and by assuming different values for the constant relative risk aversion coefficient. Instead of taking this coefficient as given, we suggest in this paper to estimate it by using the consumption data and the quotations of one of the most transacted weather contracts which is the New York weather futures on the Chicago Mercantile Exchange (CME). We will apply the wellknown generalized method of moments (GMM) introduced by Hansen (1982) to estimate it as well as the simulated method of moments (SMM) attributed to Lee and Ingram (1991) and Duffie and Singleton (1993). This last method is studied since we think that it can give satisfactory results in the case of the weather derivatives for which the prices are simulated. We find that the estimated coefficient from the SMM approach must have improbably high values in order to have the calculated weather futures prices matching the observations. This finding is in accordance with the results of the prior works which have shown the empirical failures of the consumptionbased asset pricing model. 
Keywords:  weather derivatives; consumptionbased asset pricing model; constant relative risk aversion utility function; generalized method of moments; simulated method of moments; HAC matrix; MonteCarlo simulations; periodic variance; GARCH 
Date:  2006–08–03 
URL:  http://d.repec.org/n?u=RePEc:hal:papers:halshs00088701_v1&r=upt 
By:  Raj Chetty; Adam Szeidl 
Abstract:  Many households devote a large fraction of their budgets to "consumption commitments"  goods that involve transaction costs and are infrequently adjusted. This paper characterizes risk preferences in an expected utility model with commitments. We show that commitments affect risk preferences in two ways: (1) they amplify risk aversion with respect to moderatestake shocks and (2) they create a motive to take largepayoff gambles. The model thus helps resolve two basic puzzles in expected utility theory: the discrepancy between moderatestake and largestake risk aversion and lottery playing by insurance buyers. We discuss applications of the model such as the optimal design of social insurance and tax policies, added worker effects in labor supply, and portfolio choice. Using event studies of unemployment shocks, we document evidence consistent with the consumption adjustment patterns implied by the model. 
JEL:  E2 H2 H5 J21 J64 
Date:  2006–08 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12467&r=upt 
By:  Charles Blackorby (Department of Economics, University of Warwick and GREQAM); David Donaldson (Department of Economics, University of British Columbia); John A. Weymark (Department of Economics, Vanderbilt University) 
Abstract:  This article considers measures of individual welfare change for projects that change the state distribution of prices and incomes. For a consumer whose preferences satisfy the expected utility hypothesis, we investigate whether there is an increasing function of the statecontingent compensating variations that is positive valued if and only if a project makes the consumer better off ex ante when income and some or all prices are permitted to vary across states. We show that any such measure of individual welfare change must rank projects by their expected compensating variation. Furthermore, the indirect utility function that the consumer uses to evaluate prices and income in each state and that is used to compute expected utilities must be affine in income with the origin term independent of all prices and the weight on income independent of those prices that are uncertain. These restrictions imply that preferences are homothetic. If all prices are uncertain, these conditions are inconsistent with the homogeneity properties of an indirect utility function and, hence, we obtain an impossibility result. 
Keywords:  Costbenefit, consumer's surplus, expected compensating variation 
JEL:  D61 D81 
Date:  2006–08 
URL:  http://d.repec.org/n?u=RePEc:van:wpaper:0618&r=upt 
By:  Howard Kunreuther 
Abstract:  Protective decisions are often puzzling. Among other anomalies, people insure against noncatastrophic events, underinsure against catastrophic risks, and allow extraneous factors to influence insurance purchases and other protective decisions. Neither expectedutility theory nor prospect theory can explain these anomalies satisfactorily. We propose a constructedchoice model for general decision making. The model departs from utility theory and prospect theory in its treatment of multiple goals and it suggests several different ways in which context can affect choice. To apply this model to the above anomalies, we consider many different insurancerelated goals, organized in a taxonomy, and we consider the effects of context on goals, resources, plans and decision rules. The paper concludes by suggesting some prescriptions for improving individual decision making with respect to protective measures. 
JEL:  G22 H23 
Date:  2006–08 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:12446&r=upt 
By:  Weymark, John A.; Blackorby, Charles; Donaldson, David 
Abstract:  This article considers measures of individual welfare change for projects that change the state distribution of prices and incomes. For a consumer whose preferences satisfy the expected utility hypothesis, we investigate whether there is an increasing function of the statecontingent compensating variations that is positive valued if and only if a project makes the consumer better off ex ante when income and some or all prices are permitted to vary across states. We show that any such measure of individual welfare change must rank projects by their expected compensating variation. Furthermore, the indirect utility function that the consumer uses to evaluate prices and income in each state and that is used to compute expected utilities must be affine in income with the origin term independent of all prices and the weight on income independent of those prices that are uncertain. These restrictions imply that perferences are homothetic. If all prices are uncertain, these conditions are inconsistent with the homogeneity properties of an indirect utility function and, hence we obtain an impossibility result. 
JEL:  D61 D81 
Date:  2006–08–09 
URL:  http://d.repec.org/n?u=RePEc:ubc:bricol:donaldson060809015311&r=upt 
By:  Jens Carsten Jackwerth (Department of Economics, University of Konstanz); James E. Hodder (Finance Department, University of WisconsinMadison) 
Abstract:  This paper investigates dynamically optimal risktaking by an expectedutility maximizing manager of a hedge fund. We examine the effects of variations on a compensation structure that includes a percentage management fee, a performance incentive for exceeding a specified highwater mark, and managerial ownership of fund shares. In our basic model, there is an exogenous liquidation barrier where the fund is shut down due to poor performance. We also consider extensions where the manager can voluntarily choose to shut down the fund as well as to enhance the fund’s Sharpe Ratio through additional effort. We find managerial risktaking which differs considerably from the optimal risktaking for a fund investor with the same utility function. In some portions of the state space, the manager takes extreme risks. In another area, she pursues a lockin style strategy. Indeed, the manager’s optimal behavior even results in a trimodal return distribution. We find that seemingly minor changes in the compensation structure can have major implications for risktaking. Additionally, we are able to compare results from our more general model with those from several recent papers that turn out to be focused on differing parts of the larger picture. 
Date:  2005–05–23 
URL:  http://d.repec.org/n?u=RePEc:knz:cofedp:0502&r=upt 
By:  Stephen Satchel (School of Finance and Economics, University of Technology, Sydney); Vincenzo Merella (Birbeck College, University of London) 
Abstract:  We derive a pricing formula for a European call option written on equity in a framework where returns and consumption covary with external happiness. Being a nontradable variable, happiness is regarded as an extra variable in a parameterised version of state dependent utility. We derive an extended version of the BlackScholes (BS) formula and find that, in an optimistic environment (that is, where a high growth rate of happiness is expected), the standard BS formula may underestimate the value of the call option, and overestimate its sensitivity to changes in the underlying parameters. Under the assumption of lognormality of the happiness distribution, testable hypotheses for quality of hedging strategies can also be implemented. 
Date:  2006–08–01 
URL:  http://d.repec.org/n?u=RePEc:uts:rpaper:182&r=upt 
By:  Eric Danan; Anthony Ziegelmeyer 
Abstract:  We propose an experimental design allowing a behavioral test of the axiom of completeness of individual preferences. The central feature of our design consists in enabling subjects to postpone commitment at a small cost. Our main result is that preferences are significantly incomplete. We use lotteries as choice alternatives and we find that risk aversion is globally robust to preference incompleteness. 
Keywords:  Incomplete preferences, preference for flexibility, risk aversion, indecisiveness, indifference 
JEL:  C91 D11 
Date:  2006–08 
URL:  http://d.repec.org/n?u=RePEc:esi:discus:200601&r=upt 
By:  Nadja Trhal; Ralf Radermacher 
Abstract:  We experimentally examine the impact of selfinflicted neediness on the solidarity behavior of subjects. In one treatment in our solidarity experiment all subjects face the same probability of becoming needy, in the other treatment subjects have the choice between a secure payment and a lottery including a certain probability of becoming needy. Then we ask all subjects how much they will give to losers in their group thus investigating if people are willing to give the same gifts whether or not subjects are responsible for inequality in payoffs. We found evidence for allocative as well as for procedural utility concerns. 
Keywords:  solidarity game, selfinflicted neediness, responsibility, procedural utility 
JEL:  C91 D63 
Date:  2006–08–21 
URL:  http://d.repec.org/n?u=RePEc:kls:series:0028&r=upt 