|
on Utility Models and Prospect Theories |
| By: | Frank Hansen (Department of Economics, University of Copenhagen) |
| Abstract: | We consider the risk premium demanded by a decision maker with wealth x in order to be indifferent between obtaining a new level of wealth y1 with certainty, or to participate in a lottery which either results in unchanged present wealth or a level of wealth y2 > y1. We define the relative risk premium as the quotient between the risk premium and the increase in wealth y1–x which the decision maker puts on the line by choosing the lottery in place of receiving y1 with certainty. We study preferences such that the relative risk premium is a decreasing function of present wealth, and we determine the corresponding class of utility functions which has several attractive properties and contains functions frequently used in the literature, including the power utility functions. The functions in the class are automatically continuously differentiable, and we characterize them in several ways. Decreasing relative risk premium in the small implies decreasing relative risk premium in the large, and decreasing relative risk premium everywhere implies risk aversion. We finally show that preferences with decreasing relative risk premium may be equivalently expressed in terms of certain preferences on risky lotteries. |
| Keywords: | expected utility theory; relative risk premium; preferences on lotteries |
| JEL: | D8 G12 |
| Date: | 2006–11 |
| URL: | http://d.repec.org/n?u=RePEc:kud:kuiedp:0621&r=upt |
| By: | Christian Belzil (GATE CNRS); Marco Leonardi (Università di Milano) |
| Abstract: | Using unique Italian panel data, in which individual differences in behavior toward risk are measured from answers to a lottery question, we investigate if (and to what extent) risk aversion can explain differences in schooling attainments. We formulate the schooling decision process as a reduced-form dynamic discrete choice. The model is estimated with a degree of flexibility virtually compatible with semiparametric likelihood techniques. We analyze how grade transition from one level to the next varies with preference heterogeneity (risk aversion), parental human capital, socioeconomic variables and persistent unobserved (to the econometrician) heterogeneity. We present evidence that schooling attainments decrease with risk aversion, but despite a statistically significant effect, differences in attitudes toward risk account for a modest portion of the probability of entering higher education. Differences in ability(ies) and in parental human capital are much more important. in the most general version of the model, the likelihood function is the joint probability of schooling attainments, and post-schooling wealth and risk aversion. |
| Keywords: | dynamic discrete choices, éducation, human capital, risk aversion |
| JEL: | J24 |
| Date: | 2006–10 |
| URL: | http://d.repec.org/n?u=RePEc:gat:wpaper:0607&r=upt |
| By: | Gai, Prasanna; Vause, Nicholas |
| Abstract: | This paper proposes a method for measuring investor risk appetite based on the variation in the ratio of risk-neutral to subjective probabilities used by investors in evaluating possible future returns to an asset. Unlike other indicators advanced in the literature, our measure of market sentiment distinguishes risk appetite from risk aversion, and is reported in levels rather than changes. Implementation of the approach yields results that respond to crises and other major economic events in a plausible manner. |
| Keywords: | Risk appetite; market sentiment; risk-neutral pricing; risk aversion |
| JEL: | G00 G0 |
| Date: | 2005–12–07 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:818&r=upt |
| By: | David Masclet (CREM, Department of Economics, University of Rennes 1 et CIRANO,Montréal); Youenn Loheac (Graduate School of Management of Brittany et Centre d'Economie de la Sorbonne); Laurent Denant-Boemont (CREM, Department of Economics, University of Rennes 1); Nathalie Colombier (CREM, Department of Economics, University of Rennes 1) |
| Abstract: | This paper focuses on decision making under risk, comparing group and individual risk preferences in a lottery-choice experiment inspired by Holt and Laury (2002). The experiment presents subjects with a menu of unordered lottery choices which allows us to measure risk aversion. In the individual treatment, subjects make lottery choices individually ; in the group treatment, each subject was placed in an anonymous group of three, where unanimous lottery choice decisions were made via voting. Finally, in a third treatment, called the choice treatment, subjects could choose whether to be on their own or in a group. our main findings are that groups are more likely than individuals to choose safe lotteries for decisions with low winning percentages. Moreover, groups converge toward less risky decisions because subjects who were relatively less risk averse were more likely to change their vote in order to conform to the group average decision ; more risk-averse individuals were less likely to change their preferences. Finally our results reveal a positive relationship between preference for risk and willingness to decide alone. |
| Keywords: | Experiment, decision rule, individual decision, group decision. |
| JEL: | C91 C92 D81 D70 M10 |
| Date: | 2004–10 |
| URL: | http://d.repec.org/n?u=RePEc:mse:wpsorb:bla06063&r=upt |
| By: | Péter Csóka (Department of Economics, Universiteit Maastricht); Jean-Jacques Herings (Department of Economics, Universiteit Maastricht); László Kóczy (Department of Economics, Universiteit Maastricht) |
| Abstract: | Coherent measures of risk defined by the axioms of monotonicity, subadditivity, positive homogeneity, and translation invariance are recent tools in risk management to assess the amount of risk agents are exposed to. If they also satisfy law invariance and comonotonic additivity, then we get a subclass of them: spectral measures of risk. Expected shortfall is a well-known spectral measure of risk is. We investigate the above mentioned six axioms using tools from general equi- librium (GE) theory. Coherent and spectral measures of risk are compared to the natural measure of risk derived from an exchange economy model, that we call GE measure of risk. We prove that GE measures of risk are coherent measures of risk. We also show that spectral measures of risk can be represented by GE measures of risk only under stringent conditions, since spectral measures of risk do not take the regulated entity's relation to the market portfolio into account. To give more insights, we characterize the set of GE measures of risk. |
| Keywords: | Coherent Measures of Risk, General Equilibrium Theory, Exchange Economies, Asset Pricing |
| JEL: | D51 G10 G12 |
| Date: | 2006–08–30 |
| URL: | http://d.repec.org/n?u=RePEc:has:discpr:0611&r=upt |
| By: | David De Meza; David C Webb |
| Abstract: | Compensation schemes often reward success but do not penalize failure. Fixed salaries with stock options or bonuses have this feature. Yet the standard principal–agent model implies that pay is normally monotonically increasing in performance. This paper shows that, under loss aversion, there will be intervals over which pay is insensitive to performance, with the use of carrots but not sticks is frequently optimal, especially when risk aversion is low and reference income is endogenous. A further benefit of capping losses, for example through options, is to discourage reckless behavior by executives seeking to resurrect their fortunes. (JEL: F3, F4) |
| Date: | 2006–05 |
| URL: | http://d.repec.org/n?u=RePEc:fmg:fmgdps:dp571&r=upt |
| By: | Tsvetanka Karagoyozova (University of Connecticut); Peter Siegelman (University of Connecticut) |
| Abstract: | The theory of adverse selection in insurance markets has been enormously influential among scholars, regulators, and the judiciary. But empirical support for adverse selection has been much less persuasive, and several recent studies have found little or no evidence of such selection in insurance markets. "Propitious" (advantageous) selection offers an alternative mechanism that is consistent with these empirical findings. Like adverse selection, the theory assumes that insureds have an informational advantage over insurers. However, propitious selection relies on the plausible assumption that risk aversion is negatively correlated with the riskiness or probability of loss across insureds - the more risk-averse are also the more careful, and hence are least likely to experience a loss. Theorists have recognized the possibility of equilibria in which highly risk averse insureds with a low probability of loss are willing to remain in the market, despite an actuarially unfair premium. But these conclusions derive from models with only two types of insureds. We use a simulation model that allows for flexible correlation between risk aversion and riskiness across a continuum of types, with plausible distributions of risk aversion and riskiness. We find that propitious selection alone can not preserve equilibrium in insurance markets. When insureds have moderate uncertainty about their own riskiness, however, equilibrium does become possible, albeit with considerable selection. |
| Date: | 2006–11 |
| URL: | http://d.repec.org/n?u=RePEc:uct:uconnp:2006-20&r=upt |
| By: | Andrei Semenov (Department of Economics, York University) |
| Abstract: | This paper develops an approximate equilibrium factor model for asset returns. In this model, the pricing factors are the cross-moments of return with the cross-sectional moments of individual consumption and the signs of the risk factor coefficients are driven by preference assumptions. Using household-level quarterly consumption data from the U.S. Consumer Expenditure Survey, we find that this model explains the observed equity premium with an economically realistic value of risk aversion when the stochastic discount factor is expressed in terms of the cross-sectional skewness and kurtosis, in addition to the mean and variance, of individual consumption. |
| Keywords: | asset pricing, equity premium, Euler equation, heterogeneous consumers, incomplete consumption insurance. |
| JEL: | G12 |
| Date: | 2003–12 |
| URL: | http://d.repec.org/n?u=RePEc:yca:wpaper:2003_4&r=upt |
| By: | Annamaria Fiore; M. Vittoria Levati; Andrea Morone |
| Abstract: | We use a two-person linear voluntary contribution mechanism with stochastic marginal benefits from the public good to examine the effect of imperfect information on contributions levels. To assess prior risk attitudes, individual valuations of several risky prospects are elicited via a second-price auction. We find that limited information about the productivity of the public good lowers significantly initial contributions in comparison to a setting with perfect information, whereas different information conditions do not result in qualitatively different contribution patterns. Moreover, our results show clear evidence of risk aversion, and of a negative relationship between the latter and willingness to cooperate. |
| Keywords: | Public goods experiments, Vickrey auctions, Imperfect information, Risk attitudes |
| JEL: | C72 C92 D80 H41 |
| Date: | 2006–11 |
| URL: | http://d.repec.org/n?u=RePEc:esi:discus:2006-30&r=upt |
| By: | Parrachino, Irene; Zara, Stefano; Patrone, Fioravante |
| Abstract: | Game theory provides useful insights into the way parties that share a scarce resource may plan their use of the resource under different situations. This review provides a brief and self-contained introduction to the theory of cooperative games. It can be used to get acquainted with the basics of cooperative games. Its goal is also to provide a basic introduction to this theory, in connection with a couple of surveys that analyze its use in the context of environmental problems and models. The main models (bargaining games, transfer utility, and non-transfer utility games) and issues and solutions are considered: bargaining solutions, single-value solutions like the Shapley value and the nucleolus, and multi-value solutions such as the core. The cooperative game theory (CGT) models that are reviewed in this paper favor solutions that include all possible players and ignore the strategic stages leading to coalition building. They focus on the possible results of the cooperation by answering questions such as: Which coalitions can be formed? And how can the coalitional gains be divided to secure a sustainable agreement? An important aspect associated with the solution concepts of CGT is the equitable and fair sharing of the cooperation gains. |
| Keywords: | Environmental Economics & Policies,Economic Theory & Research,Livestock & Animal Husbandry,Education for the Knowledge Economy,Education for Development |
| Date: | 2006–11–01 |
| URL: | http://d.repec.org/n?u=RePEc:wbk:wbrwps:4072&r=upt |
| By: | Martin F. Quaas (Department of Ecological Modelling, UFZ-Centre for Environmental Research Leipzig-Halle); Stefan Baumgärtner (Centre for Sustainability, University of Lüneburg) |
| Abstract: | In the face of uncertainty, ecosystems can provide natural insurance to risk averse users of ecosystem services. We employ a conceptual ecological-economic model to analyze the allocation of (endogenous) risk and ecosystem quality by risk averse ecosystem managers who have access to financial insurances, and study the implications for individually and socially optimal ecosystem management, and policy design. We show that while an improved access to financial insurance leads to lower ecosystem quality, the effect on the free-rider problem and on welfare is determined by ecosystem properties. We derive conditions on ecosystem functioning under which, if financial insurance becomes more accessible, (i) the extent of optimal regulation increases or decreases; and (ii) welfare, in the absence of environmental regulation, increases or decreases. |
| Keywords: | ecosystem quality, ecosystem services, ecosystem management, endogenous environmental risk, insurance, risk-aversion, uncertainty |
| Date: | 2006–10–26 |
| URL: | http://d.repec.org/n?u=RePEc:lue:wpaper:34&r=upt |
| By: | Martin F. Quaas (Department of Ecological Modelling, UFZ-Centre for Environmental Research Leipzig-Halle); Stefan Baumgärtner (Centre for Sustainability, University of Lüneburg) |
| Abstract: | The ecological literature suggests that biodiversity reduces the variance of ecosystem services. Thus, conservative biodiversity management has an insurance value to risk-averse users of ecosystem services. We analyze a conceptual ecological-economic model in which such management measures generate a private benefit and, via ecosystem processes at higher hierarchical levels, a positive externality on other ecosystem processes at higher hierarchical levels, a positive externality on other ecosystem users. We find that ecosystem management and environmental policy depend on the extent of uncertainty and risk-aversion as follows: (i) Individual effort to improve ecosystem quality unambiguously increases. The free-rider problem may decrease or increase, depending on the characteristics of the ecosytsem and its management; in particular, (ii) the size of the externality may decrease or increase, depending on how individual and aggregate management effort influence biodiversity; and (iii) the welfare loss due to free-riding may decrease or increase, depending on how biodiversity influences ecosystem service provision. |
| Keywords: | biodiversity, ecosystem services, ecosystem management, free-riding, insurance, public good, risk-aversion, uncertainty |
| Date: | 2006–10–26 |
| URL: | http://d.repec.org/n?u=RePEc:lue:wpaper:33&r=upt |
| By: | Oliver Hart; John Moore |
| Abstract: | We argue that a contract provides a reference point for a trading relationship: more precisely, for parties' feelings of entitlement. A party's ex post performance depends on whether he gets what he is entitled to relative to outcomes permitted by the contract. A party who is shortchanged shades on performance. A flexible contract allows parties to adjust their outcome to uncertainty, but causes inefficient shading. Our analysis provides a basis for long-term contracts in the absence of noncontractible investments, and elucidates why "employment" contracts, which fix wage in advance and allow the employer to choose the task, can be optimal. |
| JEL: | D23 D86 K12 |
| Date: | 2006–11 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:12706&r=upt |
| By: | Shaun K. Roache; Matthew D. Merritt |
| Abstract: | Large fundamental imbalances persist in the global economy, with potential exchange rate implications. This paper assesses whether exchange rate risk is priced across G-7 stock markets. Given the multitude of hedging instruments available, theory suggests that stock market investors should not be compensated for currency risk. However, data covering 33 industry portfolios across seven major stock markets suggest that not only is exchange rate risk priced in many markets, but that it is time-varying and sensitive to currency-specific shocks. With stock market investors typically exhibiting "home bias," this suggests that investors are using equity asset proxies to hedge the exchange rate risks to consumption. |
| Keywords: | arbitrage pricing theory , risk prices , asset pricing , Stock markets , Arbitrage , Asset prices , |
| Date: | 2006–09–05 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:06/194&r=upt |
| By: | S. Nuri Erbas; Chera L. Sayers |
| Abstract: | Knightian uncertainty (ambiguity) implies presence of uninsurable risks. Institutional quality may be a good indicator of Knightian uncertainty. This paper correlates non-life insurance penetration in 70 countries with income level, financial sector depth, country risk, a measure of cost of insurance, and the World Bank governance indexes. We find that institutional quality-transparency-uncertainty nexus is the dominant determinant of insurability across countries, surpassing the explanatory power of income level. Institutional quality, as it reflects on the level of uncertainty, is the deeper determinant of insurability. Insurability is lower when governance is weaker. |
| Keywords: | Institutional quality , Knightian Uncertainty , insurability , |
| Date: | 2006–08–04 |
| URL: | http://d.repec.org/n?u=RePEc:imf:imfwpa:06/179&r=upt |
| By: | Kukushkin, Nikolai S. |
| Abstract: | Maximal elements of a binary relation on compact subsets of a metric space define a choice function. Necessary and sufficient conditions are found for: (1) the choice function to have nonempty values and be path independent; (2) the choice function to have nonempty values provided the underlying relation is an interval order. For interval orders and semiorders, the same properties are characterized in terms of representations in a chain. |
| Keywords: | Maximal element; Path independence; Interval order; Semiorder |
| JEL: | D71 |
| Date: | 2006–11–09 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:803&r=upt |
| By: | Danny Campbell (Gibson Institute of Land, Food and Environmen, Queen’s University Belfast); W. George Hutchinson (Gibson Institute of Land, Food and Environmen, Queen’s University Belfast); Riccardo Scarpa (University of Waikato) |
| Abstract: | In discrete choice experiments respondents are generally assumed to consider all of the attributes across each of the alternatives, and to choose their most preferred. However, results in this paper indicate that many respondents employ simplified lexicographic decision-making rules, whereby they have a ranking of the attributes, but their choice of an alternative is based solely on the level of their most important attribute(s). Not accounting for these simple decision-making heuristics introduces systemic errors and leads to biased point estimates, as they are a violation of the continuity axiom and a departure from the use of compensatory decision-making. In this paper the implications of lexicographic preferences are examined. In particular, using a mixed logit specification this paper investigates the sensitivity of individual-specific willingness to pay (WTP) estimates conditional on whether lexicographic decision-making rules are accounted for in the modelling of discrete choice responses. Empirical results are obtained from a discrete choice experiment that was carried out to address the value of a number of rural landscape attributes in Ireland. |
| Keywords: | Continuity axiom, Discrete Choice Experiments, Lexicographic Preferences, Mixed Logit, Individual-Specific Willingness to Pay |
| JEL: | C35 Q24 Q51 |
| Date: | 2006–10 |
| URL: | http://d.repec.org/n?u=RePEc:fem:femwpa:2006.128&r=upt |