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on Utility Models and Prospect Theory |
| By: | Christian Gollier (University of Toulouse); Alexander Muermann (University of Pennsylvania, The Wharton School) |
| Abstract: | We propose a new decision criterion under risk in which people extract both utility from anticipatory feelings ex ante and disutility from disappointment ex post. The decision maker chooses his degree of optimism, given that more optimism raises both the utility of ex ante feelings and the risk of disappointment ex post. We characterize the optimal beliefs and the preferences under risk generated by this mental process and apply this criterion to a simple portfolio choice/insurance problem. We show that these preferences are consistent with the preference reversal in the Allais’ paradoxes and predict that the decision maker takes on less risk compared to an expected utility maximizer. This speaks to the equity premium puzzle and to the preference for low deductibles in insurance contracts. Keywords: endogenous beliefs, anticipatory feeling, disappointment, optimism, decision under risk, portfolio allocation. |
| Keywords: | Endogenous Beliefs, Anticipatory Feeling, Disappointment, Optimism, Decision Under Risk, Portfolio Allocation |
| JEL: | D81 G11 |
| Date: | 2006–12–08 |
| URL: | http://d.repec.org/n?u=RePEc:cfs:cfswop:wp200628&r=upt |
| By: | Paul Dolan; Oyeyemi Oluboyede; Jennifer Roberts (Department of Economics, The University of Sheffield) |
| Abstract: | Expected Utility (EU) theory is the standard economic model of individual preferences under uncertainty. However, observed violations of the axioms of EU have generated interest in the incorporation of a stochastic element into deterministic models of decision-making. Previous empirical investigation of the theories of stochastic choice has involved monetary gambles in risky conditions using convenience samples of students. The aim of this study is to test generalisations of these models in the context of eliciting the preferences of the general public over health states under conditions of certainty. Our findings lend support to the `white noise´ stochastic specification of Hey and Orme (1994) which indicates that the stronger the preferences of an individual, the less likely they are to make a mistake and attach a lower value to their truly preferred alternative. JEL Classification: D0 Key words: Stochastic preferences, utility assessment, expected utility theory. |
| Keywords: | Stochastic preferences, utility assessment, expected theory |
| JEL: | D0 |
| Date: | 2005–11 |
| URL: | http://d.repec.org/n?u=RePEc:shf:wpaper:2005017&r=upt |
| By: | Sarah Brown; Karl Taylor (Department of Economics, The University of Sheffield) |
| Abstract: | We explore the effect of risk preference on the educational attainment and wages of a sample of individuals drawn from the U.S. Panel Study of Income Dynamics (PSID). Using a sequence of questions from the 1996 PSID, we are able to construct measures of risk aversion and risk tolerance allowing us to explore the implications of interpersonal differences in risk preference for educational attainment. Our empirical findings suggest that risk preference has a significant influence on human capital accumulation, with the degree of risk aversion (tolerance) being inversely (positively) associated with educational attainment. In addition, our findings suggest that risk preference is a valid instrument for education in a standard Mincerian earnings function. |
| Keywords: | Human Capital, Risk Aversion, Risk Preference, Wages. |
| JEL: | J24 J30 |
| Date: | 2006–02 |
| URL: | http://d.repec.org/n?u=RePEc:shf:wpaper:2006002&r=upt |
| By: | Rachel A. Campbell (Maastricht University); Roman Kräussl (Free University of Amsterdam and CFS) |
| Abstract: | Deviations from normality in financial return series have led to the development of alternative portfolio selection models. One such model is the downside risk model, whereby the investor maximizes his return given a downside risk constraint. In this paper we empirically observe the international equity allocation for the downside risk investor using 9 international markets’ returns over the last 34 years. The results are stable for various robustness checks. Investors may think globally, but instead act locally, due to greater downside risk. The results provide an alternative view of the home bias phenomenon, documented in international financial markets. |
| Keywords: | Asset Pricing, Home Bias, Downside Risk, Prospect Theory |
| JEL: | G11 G12 G15 |
| Date: | 2006–12–20 |
| URL: | http://d.repec.org/n?u=RePEc:cfs:cfswop:wp200631&r=upt |
| By: | Huisman, R.; Mahieu, R.J.; Schlichter, F. (Erasmus Research Institute of Management (ERIM), RSM Erasmus University) |
| Abstract: | This paper deals with the question how an electricity end-consumer or distribution company should structure its portfolio with energy forward contracts. This paper introduces a one period framework to determine optimal positions in peak and off-peak contracts in order to purchase future consumption volume. In this framework, the end-consumer or distribution company is assumed to minimize expected costs of purchasing respecting an ex-ante risk limit defined in terms of Value at Risk. Based on prices from the German EEX market, it is shown that a risk-loving agent is able to obtain lower expected costs than for a risk-averse agent. |
| Keywords: | Electricity prices;Mean variance;Hedge ratios;Forward risk premium; |
| Date: | 2007–02–21 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:eureri:30009941&r=upt |
| By: | Gary W. Yohe; Richard S.J. Tol (Economic and Social Research Institute, Dublin) |
| Abstract: | Using a simple model designed for transparency but nonetheless calibrated to support the much-quoted damage estimates of the Stern Review of the Economics of Climate Change, we demonstrate significant sensitivity of those results to assumptions about the pure rate of time preference, the discounting time horizon, rates of risk and equity aversion used to compute certainty- and equity equivalent annuities, and presumed static regional vulnerability. Manipulation of any of these parameters one at a time across reasonable ranges can diminish damage estimates by as much as 84% or, in the case of extending the time horizon, increase damage estimates by 900%. We also confirm the usual result that limiting atmospheric concentrations to specific benchmarks above 400 ppm cannot eliminate damages. Nonetheless, we applaud the Stern Review author team for reconfirming that the climate problem can productively be approached as an economic problem whose solutions can be explored with the tools of decision analysis. |
| Keywords: | economics of climate change, certainty equivalent and equity equivalent annuity, relative risk aversion, equity aversion, pure rate of time preference |
| JEL: | Q54 |
| Date: | 2007–02 |
| URL: | http://d.repec.org/n?u=RePEc:sgc:wpaper:125&r=upt |