nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2007‒04‒09
23 papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Empirical Pricing Kernels and Investor Preferences By Kai Detlefsen; Wolfgang Härdle; Rouslan Moro
  2. "Are the Costs of the Business Cycle 'Trivially Small'?" By Greg Hannsgen
  3. Preferences over Consumption and Status By Vostroknutov, Alexander
  4. Joker: Choice in a simple game with large stakes By Egil Matsen; Bjarne Strøm
  5. Guilt Aversion and Insincerity-Induced Disutility By Amegashie, J.A.
  6. Dynamic Choice Under Ambiguity By Marciano Siniscalchi
  7. Two-Fund Separation in Dynamic General Equilibrium By Karl Schmedders
  8. Portfolio Choice Beyond the Traditional Approach By Francisco Peñaranda
  9. ICAPM with time-varying risk aversion By Paulo Maio
  10. Why the Ultimatum Game is not the Ultimate Experiment By Peters, Michael; Halevy, Yoram
  11. Does Risk Aversion Drive Financial Crises? Testing the Predictive Power of Empirical Indicators By Virginie Coudert; Mathieu Gex
  12. Risk, Government andd Globalization: International Survey Evidence By Anna Maria Mayda; Kevin H. O'Rourke
  13. Liquidity Risk Aversion, Debt Maturity, and Current Account Surpluses: A Theory and Evidence from East Asia By Shin-ichi Fukuda; Yoshifumi Kon
  14. "Liquidity Risk Aversion, Debt Maturity, and Current Account Surpluses: A Theory and Evidence from East Asia" By Shin-ichi Fukuda; Yoshifumi Kon
  15. A Micro- Foundation for Non-Deterministic Contests of the Logit Form By Matthias Dahm; Nicolas Porteiro
  16. Segregation and Strategic Neighborhood Interaction By Jason Barr; Troy Tassier
  17. Optimal Gradual Annuitization: Quantifying the Costs of Switching to Annuities By Raimond Maurer; Wolfram Horneff; Michael Stamos
  18. Convergence of a Dynamic Matching and Bargaining Market with Two-sided Incomplete Information to Perfect Competition By Mark Satterthwaite; Artyom Shneyerov
  19. Unemployment Insurance in an Economy with a Hidden Labor Market By Alvarez-Parra, Fernando A.; Sanchez, Juan M.
  20. The Dynamic Evolution of Preferences By Aviad Heifetz; Chris Shannon; Yossi Spiegel
  21. Temptation–Driven Preferences By Eddie Dekel; Barton Lipman; Aldo Rustichini
  22. The problem of prevention By Benoit, Jean-Pierre; Dubra, Juan
  23. Assessing the Relation between Equity Risk Premia and Macroeconomic Volatilities By Renatas Kizys; Peter Spencer

  1. By: Kai Detlefsen; Wolfgang Härdle; Rouslan Moro
    Abstract: This paper analyzes empirical market utility functions and pricing kernels derived from the DAX and DAX option data for three market regimes. A consistent parametric framework of stochastic volatility is used. All empirical market utility functions show a region of risk proclivity that is reproduced by adopting the hypothesis of heterogeneous individual investors whose utility functions have a switching point between bullish and bearish attitudes. The inverse problem of finding the distribution of individual switching points is formulated in the space of stock returns by discretization as a quadratic optimization problem. The resulting distributions vary over time and correspond to different market regimes.
    Keywords: Utility function, Pricing Kernel, Behavioral Finance, Risk Aversion, Risk Proclivity, Heston model.
    JEL: G12 G13 C50
    Date: 2007–04
  2. By: Greg Hannsgen
    Abstract: In his presidential address to the American Economic Association, Robert Lucas claimed that the welfare costs of the business cycle in the United States equaled .05 percent of consumption. His calculation compared the utility of a representative consumer receiving actual per-capita consumption each year with that of a similar consumer receiving the expectation of consumption. To a risk-averse person, the latter path of consumption confers more utility, because it is less volatile. Applying Amartya SenÕs chooser-dependent preferences to a nonÐexpected utility case, I will counter LucasÕs claim by arguing that people have different attitudes toward risk that is imposed and risk that is voluntarily taken on, and that policymakers, in carrying out public duties, must use sorts of reasoning different from those used by the optimizing consumers of neoclassical economic theory.
    Date: 2007–03
  3. By: Vostroknutov, Alexander
    Abstract: Recent experimental evidence suggests that social status has significant influence on economic behavior. The objects desired for status often have consumption value as well. In order to distinguish whether status or consumption drives the behavior it is necessary to have a model of interdependent preferences which allows for their unambiguous separation. The axioms in the paper describe the preferences that have unique expected utility representation with consumption and status entering additively. This makes it possible to estimate the relative importance of consumption and status in economic decisions.
    Keywords: Interdependent preferences; status; subjective probability
    JEL: D11 C90 D01
    Date: 2007–02
  4. By: Egil Matsen (Department of Economics, Norwegian University of Science and Technology); Bjarne Strøm (Department of Economics, Norwegian University of Science and Technology)
    Abstract: This paper examines data from the Norwegian television game show Joker, where contestants make well-specified choices under risk. The game involves very large stakes, randomly drawn contestants, and ample opportunities for learning. Expected utility (EU) theory gives a simple prediction of choice under weak conditions, as one choice is always first-order stochastically dominating. We document frequent, systematic and costly violations of dominance. Most alternative theories fail to add explanatory power beyond the EU benchmark, but many contestants appear to have a systematic expectation bias that can be related to Tversky and Kahneman?s (1973) "availability heuristic". In addition, there seems to be a stochastic element in choice that is well captured by the so-called Fechner model.
    Keywords: Risky choice; stochastic dominance; choice models; stakes; game show
    JEL: C9 C93 D81
    Date: 2006–12–19
  5. By: Amegashie, J.A.
    Date: 2006
  6. By: Marciano Siniscalchi
    Abstract: This paper analyzes sophisticated dynamic choice for ambiguity-sensitive decision makers. It characterizes Consistent Planning via axioms on preferences over decision trees. Furthermore, it shows how to elicit conditional preferences from prior preferences. The key axiom is a weakening of Dynamic Consistency, deemed Sophistication. The analysis accommodates arbitrary decision models and updating rules. Hence, the results indicate that (i) ambiguity attitudes, (ii) updating rules, and (iii) sophisticated dynamic choice are mutually orthogonal aspects of preferences. As an example, a characterization of prior-by-prior Bayesian updating and Consistent Planning for arbitrary maxmin-expected utility preferences is presented. The resulting sophisticated MEU preferences are then used to analyze the value of information under ambiguity; a basic trade-off between information acquisition and commitment is highlighted.
  7. By: Karl Schmedders
    Abstract: The purpose of this paper is to examine the two-fund separation paradigm in the context of an infinite-horizon general equilibrium model with dynamically complete markets and heterogeneous consumers with time and state separable utility functions. With the exception of the dynamic structure, we maintain the assumptions of the classical static models that exhibit two-fund separation with a riskless security. In addition to a se- curity with state-independent payoffs agents can trade a collection of assets with dividends following a time-homogeneous Markov process. We make no further assumptions about the distribution of asset dividends, returns, or prices. Agents have equi-cautious HARA utility functions. If the riskless security in the economy is a consol then agents' portfolios exhibit two-fund separation. But if agents can trade only a one-period bond, this result no longer holds. Examples show this effect to be quantitatively signifcant. The underly- ing intuition is that general equilibrium restrictions lead to interest rate °uctuations that destroy the optimality of two-fund separation in economies with a one-period bond and result in different equilibrium portfolios.
  8. By: Francisco Peñaranda
    Abstract: This paper surveys asset allocation methods that extend the traditional approach. An important feature of the the traditional approach is that measures the risk and return tradeoff in terms of mean and variance of final wealth. However, there are also other important features that are not always made explicit in terms of investor’s wealth, information, and horizon: The investor makes a single portfolio choice based only on the mean and variance of her final financial wealth and she knows the relevant parameters in that computation. First, the paper describes traditional portfolio choice based on four basic assumptions, while the rest of the sections extend those assumptions. Each section will describe the corresponding equilibrium implications in terms of portfolio advice and asset pricing.
    Keywords: Mean-Variance Analysis, Background Risks, Estimation Error, Expected Utility, Multi-Period Portfolio Choice
    JEL: D81 G11 G12
    Date: 2007–03
  9. By: Paulo Maio (New University of Lisbon)
    Abstract: A derivation of the ICAPM in a very general framework and previous theoretical work, argue for the relative risk aversion (RRA) coefficient to be both time-varying and countercyclical. The variables that represent proxies for the cyclical component of RRA are the market dividend yield, default spread, smoothed earnings yield and industrial production growth, all being highly correlated with the business cycle. In addition, the value spread - a proxy for the relative valuation of value stocks versus growth stocks - is included as a determinant of risk aversion. The results show that risk aversion is countercyclical, and the ICAPM with time-varying RRA performs better than the Bad beta good beta model (BBGB) from Campbell and Vuolteenaho (2004). The results from an augmented scaled ICAPM show that the market return has a negative effect on risk aversion, thus risk aversion seems to be affected by both business conditions and financial wealth. The estimates of the average RRA coefficient seem reasonable and plausible, and the model is able to capture a significant decline in risk-aversion in the 90's, in line with the mounting evidence from academics and practioneers. When compared against alternative factor models - CAPM, Fama-French 3 factor and Fama-French 4 factor models - the scaled ICAPM performs much better than the CAPM, and compares reasonably well against the Fama-French models. A crucial result relies on the fact that the scaled ICAPM models do a good job in pricing both the "extreme" small-growth portfolio and all the book-to-market quintiles, which is mainly due to the presence of the factor related with time-varying risk-aversion. Overall, the results of this paper offer a fundamental explanation - time-varying risk aversion - for the value premium. Preliminary results suggest that the ad-doc HML and UMD factors, at least partially, measure the same types of risks as the ICAPM with time-varying risk aversion
    JEL: G11 G12 G14
    Date: 2007–02–02
  10. By: Peters, Michael; Halevy, Yoram
    Abstract: The Ultimatum Game seems to be the ideal experiment to test the sequential rationality assumptions underlying subgame perfection. We illustrate with a simple example why this interpretation of the experimental results may be misguided. Instead, we approach the ultimatum game as a mechanism designed to elicit information about the preferences and beliefs of players. While remaining agnostic about the right way to interpret preferences, we maintain the assumption that preferences are interdependent - the utility of a player may be a function of other players types. We explain how to recast the best known explanations of the experimental evidence in these terms. We then illustrate how standard arguments can be used to extract the information conveyed by existing experimental results, and how the latter can restrict the set of plausible models of interdependence.
    Date: 2007–03–31
  11. By: Virginie Coudert; Mathieu Gex
    Abstract: Financial institutions often refer to empirical risk aversion indicators to gauge investors’ market sentiment. Fluctuations in risk aversion are generally considered as a factor explaining crises. Periods of strong risk appetite can create speculative bubbles on financial prices, building up vulnerabilities. Then a sudden reversal in risk aversion may trigger sharp falls in asset prices and prompt a financial crisis. A crucial point is to clearly define the concept of risk aversion. In the framework of asset pricing models, more precisely the Consumption CAPM (CCAPM), a risk premium can be decomposed into a “price of risk”, which is common to all assets, and a “quantity of risk”, which is specific to each asset. The empirical indicators of risk aversion used by financial institutions aim at assessing this “price of risk”. Those empirical indicators can be put together in four main groups. 1) The indicators of the GRAI (Global Risk Aversion Index) type are based on the idea that an increase in risk aversion should lead to a rise in risk premia across all markets, but the rise should be greater on the riskiest markets (Persaud, 1996, Kumar and Persaud, 2002). By using the CAPM, regarded as a special case of the CCAPM, this idea amounts to assessing changes in risk aversion as the correlation between price changes and their volatility. 2) Risk aversion can also be estimated as the common factor driving risk premia. This common factor can be evaluated through a factor analysis such as the Principal Component Analysis (PCA). 3) Some financial institutions also use raw series, as the VIX which is the implied volatility on the S&P 500, or combinations of raw series. 4) There are also other indicators, such as the State Street’s one which does not fall into the previous categories.
    Keywords: Risk aversion; leading indicators of crises; currency crises; stock market crises; crises prediction; models; financial markets; crisis
    JEL: C33 E44 F37 G12
    Date: 2007–01
  12. By: Anna Maria Mayda; Kevin H. O'Rourke
    Abstract: This paper uses international survey data to document two stylized facts. First, risk aversion is associated with anti-trade attitudes. Second, this effect is smaller in countries with greater levels of government expenditure. The paper thus provides evidence for the microeconomic underpinnings of the argument associated with Ruggie (1982), Rodrik (1998) and others that government spending can bolster support for globalization by reducing the risk associated with it in the minds of voters.
    Keywords: Trade attitudes, risk
    Date: 2007–04–04
  13. By: Shin-ichi Fukuda; Yoshifumi Kon
    Abstract: The purpose of this paper is to show that macroeconomic impacts might be very different depending on what strategy developing countries will take. In the first part, we investigate what macroeconomic impacts an increased aversion to liquidity risk can have in a simple open economy model. When the government keeps foreign reserves constant, an increased aversion to liquidity risk reduces liquid debt and increases illiquid debt. However, its macroeconomic impacts are not large, causing only small current account surpluses. In contrast, when the government responds to the shock, the changed aversion increases foreign reserves and may lead to a rise of liquidity debt. In particular, under some reasonable parameter set, it causes large macroeconomic impacts, including significant current account surpluses. In the second part, we provide several empirical supports to the implications. In particular, we explore how foreign debt maturity structures changed in East Asia. We find that many East Asian economies reduced short-term borrowings temporarily after the crisis but increased short-term borrowings in the early 2000s. We discuss that our results have important implications for the recent deterioration in the U.S. current account.
    JEL: F21 F32 F34
    Date: 2007–04
  14. By: Shin-ichi Fukuda (Faculty of Economics, University of Tokyo); Yoshifumi Kon (Graduate School of Economics, University of Tokyo)
    Abstract: After a series of crises, many developing countries came to recognize that reducing liquidity risk is an important self-protection. However, they have alternative strategies for the self-protection. The purpose of this paper is to show that macroeconomic impacts might be very different depending on which strategy developing countries will take. In the first part, we investigate what macroeconomic impacts an increased aversion to liquidity risk can have in a simple open economy model. When the government keeps foreign reserves constant, an increased aversion to liquidity risk reduces liquid debt and increases illiquid debt. However, its macroeconomic impacts are not large, causing only small current account surpluses. In contrast, when the government responds to the shock, the changed aversion increases foreign reserves and may lead to a rise of liquidity debt. In particular, under some reasonable parameter set, it causes large macroeconomic impacts, including significant current account surpluses. In the second part, we provide several empirical supports to the implications. In particular, we explore how foreign debt maturity structures changed in East Asia. We find that many East Asian economies reduced short-term borrowings temporarily after the crisis but increased short-term borrowings in the early 2000s. Since short-term debt is liquid debt, the instantaneous change after the crisis is consistent with the case where only private agents responded to increased aversion to liquidity risk. However, accompanied by substantial rises in foreign exchange reserves, the change in the early 2000s is consistent with the case where the government also started to respond. We discuss that our results have important implications for the recent deterioration in the U.S. current account.
    Date: 2007–04
  15. By: Matthias Dahm; Nicolas Porteiro
    Abstract: In models of non-deterministic contest, players exert irreversible effort in order to increase their probability of winning a prize. The most prominent functional form of the win probability in the literature is the so-called “logit” contest success function. We provide a simple micro-foundation of this function for the two contestant case. In this setting the contest administrator is a rational decision maker whose optimal choice is deterministic. However, from the point of view of the contestants the outcome of the contest is probabilistic because of an underlying uncertainty about the type of the administrator.
    Keywords: Contests, Contest Success Function, Effort levels, Endogenous Contest.
    JEL: C72 D72 D74
  16. By: Jason Barr; Troy Tassier
    Abstract: We introduce social interactions into the Schelling model of residential choice. These social interactions take the form of a Prisoner's Dilemma game played with neighbors. First, we study the Schelling model over a wide range of utility functions and then proceed to study a spatial Prisoner's Dilemma model. These models provide a benchmark for studying a combined model with preferences over like-typed neighbors and payoffs in the spatial Prisoner's Dilemma game. We study this combined model both analytically and using agent-based simulations. We find that the presence of these additional social interactions may increase or decrease segregation compared to the standard Schelling model. If the social interactions result in cooperation then segregation is reduced, otherwise it is increased.
    Keywords: Schelling Tipping Model, Spatial Prisoner's Dilemma, Cooperation, Segregation
    JEL: C63 C73 D62
    Date: 2007–04
  17. By: Raimond Maurer; Wolfram Horneff; Michael Stamos
    Abstract: We compute the optimal dynamic asset allocation policy for a retiree with Epstein-Zin utility. The retiree can decide how much he consumes and how much he invests in stocks, bonds, and annuities. Pricing the annuities we account for asymmetric mortality beliefs and administration expenses. We show that the retiree does not purchase annuities only once but rather several times during retirement (gradual annuitization). We analyze the case in which the retiree is restricted to buy annuities only once and has to perform a (complete or partial) switching strategy. This restriction reduces both the utility and the demand for annuities.
    JEL: D91 G11 G22 H55 J26
    Date: 2007–02
  18. By: Mark Satterthwaite; Artyom Shneyerov
    Abstract: Consider a decentralized, dynamic market with an infinite horizon in which both buyers and sellers have private information concerning their values for the indivisible traded good. Time is discrete, each period has length ?, and each unit of time a large number of new buyers and sellers enter the market to trade. Within a period each buyer is matched with a seller and each seller is matched with zero, one, or more buyers. Every seller runs a first price auction with a reservation price and, if trade occurs, both the seller and winning buyer exit the market with their realized utility. Traders who fail to trade either continue in the market to be rematched or become discouraged with probability ?? (? is the discouragement rate) and exit with zero utility. We characterize the steady-state, perfect Bayesian equilibria as ? becomes small and the market–in effect– becomes large. We show that, as ? converges to zero, equilibrium prices at which trades occur converge to the Walrasian price and the realized allocations converge to the competitive allocation.
  19. By: Alvarez-Parra, Fernando A.; Sanchez, Juan M.
    Abstract: This paper considers the problem of optimal unemployment insurance in a moral hazard framework. Unlike existing literature, unemployed workers can secretly participate in a hidden labor market; as a consequence, an endogenous lower bound for promised utility preventing "immiserization" arises. Moreover, the presence of a hidden labor market makes possible an extra deviation and therefore hardens the provision of incentives. Under linear cost of effort, we show that the optimal contract prescribes no participation in the hidden labor market and a decreasing sequence of unemployment payments until the lower bound for promised utility is reached. At that moment, participation jumps and unemployment payments drop down to zero. For the case of non-linear effort cost we calibrate the model to Spain. As in the linear cost of effort, this exercise reproduces no participation and decreasing payments during the initial phase of unemployment. After around three years of unemployment, the contract prescribes a jump in participation and an abrupt decline in unemployment payments. To the best of our knowledge, this is the first paper justifying an abrupt drop in unemployment payments. In addition, the quantitative analysis suggests that in an environment in which agents differ in separation rate, the hidden labor market reinforces the benefits from a type-dependent unemployment system.
    Keywords: Unemployment Insurance; Hidden Labor Markets; Moral Hazard; Recursive Contracts
    JEL: J68 D82
    Date: 2006–12
  20. By: Aviad Heifetz; Chris Shannon; Yossi Spiegel
    Abstract: This paper develops a general methodology for characterizing the dynamic evolution of preferences in a wide class of strategic interactions. We give simple conditions characterizing the limiting distribution of preferences in general games, and apply our results to study the evolutionary emergence of overconfidence and interdependent preferences. We also show that this methodology can be adapted to cases where preferences are only imperfectly observed.
    Keywords: dispositions, evolution of preferences, selection dynamics, perception biases, interdependent preferences, imperfect observability
  21. By: Eddie Dekel; Barton Lipman; Aldo Rustichini
    Abstract: What behavior can be explained using the hypothesis that the agent faces temptation but is otherwise a “standard rational agent”? In earlier work, Gul–Pesendorfer [2001] use a set betweenness axiom to restrict the set of preferences considered by Dekel, Lipman, and Rustichini [2001] to those explainable via temptation. We argue that set betweenness rules out plausible and interesting forms of temptation including some which may be important in applications. We propose a pair of alternative axioms called DFC, desire for commitment, and AIC, approximate improvements are chosen. DFC characterizes temptation as situations where given any set of alternatives, the agent prefers committing herself to some particular item from the set rather than leaving herself the flexibility of choosing later. AIC is based on the idea that if adding an option to a menu improves the menu, it is because that option is chosen under some circumstances. From this interpretation, the axiom concludes that if an improvement is worse (as a commitment) than some commitment from the menu, then the best commitment from the menu is strictly preferred to facing the menu. We show that these axioms characterize a natural generalization of the Gul–Pesendorfer representation.
  22. By: Benoit, Jean-Pierre; Dubra, Juan
    Abstract: Many disasters are foreshadowed by insufficient preventative care. In this paper, we argue that there is a true problem of prevention, in that insufficient care is often the result of rational calculations on the part of agents. We identify three factors that lead to dubious efforts in care. First, when objective risks of a disaster are poorly understood, positive experiences may lead to an underestimation of these risks and a corresponding underinvestment in prevention. Second, redundancies designed for safety may lead agents to take substandard care. Finally, elected officials have an incentive to underinvest in prevention for some disasters, especially those that are relatively unlikely.
    Keywords: Prevention; Accidents; Volunteer's Dilemma; Learning; Career Concerns.
    JEL: D83 D81 D82
    Date: 2006–03–29
  23. By: Renatas Kizys (Department of Economics and Related Studies, University of York); Peter Spencer (Department of Economics and Related Studies, University of York)
    Abstract: In this paper, we used modified multivariate EGARCH-M models to assess the relation between the equity risk premium, macroeconomic risk, and inflationary expectations. To rationalise this link between equity risk premia and macroeconomic volatilities, we built our empirical study on the stochastic discount factor (SDF) model. As an innovative feature of our empirical model, we used long-term government bond yields in order to explain this risk-return relation. Our research suggests that stock market investors should use long-term government bond yield for the UK and term spread for the US in order to instrument their assessment of stock market investment opportunities and riskiness. We also document that the relevance of the short-term interest rates has decreased over the last decade, whereas the relevance of the long-term government bond yields, by contrast, has increased. With regard to the risk-return relation, we found the UK investors tend to significantly price in inflation risk premia. Estimation results strongly suggest that the decline in macroeconomic volatilities might have played an increasingly important role in reducing risk premia in the US and, to some extent, in the UK
    Keywords: Asset pricing, Risk premium, Macroeconomic volatility, Stochastic discount factor model, Multivariate EGARCH-M model
    JEL: E32 E44 G12
    Date: 2007–02–02

This nep-upt issue is ©2007 by Alexander Harin. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.