|
on Utility Models and Prospect Theory |
| By: | Alpanda, Sami; Woglom, Geoffrey |
| Abstract: | Utility modeled as a power function is commonly used in the literature despite the fact that it is unbounded and generates asset pricing puzzles. The unboundedness property leads to St. Petersburg paradox issues and indifference to compound gambles, but these problems have largely been ignored. The asset pricing puzzles have been solved by introducing habit formation to the usual power utility. Given these issues, we believe it is time re-examine exponential utility. Exponential utility was abandoned largely because it implies increasing relative risk aversion in a cross-section of individuals and nonstationarity of the aggregate consumption to wealth ratio, contradicting macroeconomic data. We propose an alternative preference specification with exponential utility and relative habit formation. We show that this utility function is bounded, consistent with asset pricing facts, generates near-constant relative risk aversion in a cross-section of individuals and a stationary ratio of aggregate consumption to wealth. |
| Keywords: | unbounded utility; asset pricing puzzles; habit formation |
| JEL: | D81 G11 |
| Date: | 2007–07 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:5897&r=upt |
| By: | Hill, Brian |
| Abstract: | This paper is concerned with the representation of preferences which do not satisfy the ordinary axioms for state-independent utilities. |
| Keywords: | Elicitation; Subjective Probability; Subjective Expected Utility; Statedependent utility; Small worlds |
| JEL: | C60 D81 |
| Date: | 2007–07–13 |
| URL: | http://d.repec.org/n?u=RePEc:ebg:heccah:0874&r=upt |
| By: | Ricardo M. Sousa (Universidade do Minho - NIPE) |
| Abstract: | Modern literature departs from time-separable constant relative risk aversion preferences to explain asset pricing facts. This deviation typically implies that wealth shocks generate transitory variations in agents’ relative risk aversion and, possibly, portfolio re-allocations over time. I empirically analyze this relationship using U.S. macroeconomic data and and evidence for time-variation in portfolio shares that is consistent with counter-cyclical risk aversion. These results suggest, therefore, that wealth-dependent, habit-formation or loss and disappointment aversion utility functions are a good description of preferences. Controlling for observed versus expected asset returns, I also show that: (i) wealth effects are significant (although temporary) and there is no evidence of inertia contrary to Brunnermeier and Nagel (2006); and (ii) the consumption-wealth ratio (Lettau and Ludvigson, 2001), the labor income risk (Julliard, 2004) and the labor income-consumption ratio (Santos and Veronesi, 2006) partially explain changes in the risky asset share. |
| Keywords: | wealth, risk aversion. |
| JEL: | E21 G11 E44 |
| Date: | 2007 |
| URL: | http://d.repec.org/n?u=RePEc:nip:nipewp:28/2007&r=upt |
| By: | Amine Jalal (Goldman Sachs International) |
| Abstract: | In this paper, dynamic option-based investment strategies are derived and illustrated for investors exhibiting downside loss aversion. The problem is solved in closed form when the stock market exhibits stochastic volatility and jumps. The specification of downside loss averse utility functions allows corresponding terminal wealth profiles to be expressed as options on the stochastic discount factor contingent on the loss aversion level. Therefore dynamic strategies reduce to the replicating portfolio using exchange traded and well selected options, and the risky stock |
| Keywords: | Asset allocation, Downside risk, Stochastic volatility, jumps. |
| JEL: | G11 G12 |
| Date: | 2007–09 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp0734&r=upt |
| By: | Dominique, C-Rene |
| Abstract: | This note takes a retrospective look at the Utility Construct still in use in economic science and compares it to a new approach based on recent findings in neuroscience. The results show that it is more natural and more compelling to go from the preference order to the price vector. Thus making the non-falsifiable utility apparatus superfluous. |
| Keywords: | Well-ordered Preference Relation; C2 Utility Function; Well-defined Individual Demand Function; and Neuroeconomics. |
| JEL: | B40 A12 A10 |
| Date: | 2007–11–27 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:5987&r=upt |
| By: | Marc Oliver Rieger (University of Zurich) |
| Abstract: | We study how the framework of classical game theory changes when the preferences of the players are described by Prospect Theory instead of Expected Utility Theory. Specifically, we study the influence of framing effect and probability weighting on the existence and specific structure of Nash equilibria in pure and mixed strategies for finite games. We demonstrate that in games representing typical interactions in societies, probability weighting of the players can lead to larger common wealth and is, under weak assumptions,evolutionary stable. This observation may provide a possible explanation for the validity of Prospect Theory as a descriptive model in human behavior. |
| Keywords: | Prospect Theory, Existence of Nash Equilibria, Evolutionary stability. |
| JEL: | C70 C73 D81 |
| Date: | 2007–09 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp0729&r=upt |
| By: | Tengstam, Sven (Department of Economics, School of Business, Economics and Law, Göteborg University) |
| Abstract: | Many argue that disability generally lowers the marginal utility of income. This paper questions this view. Individuals’ marginal utility (measured by a von Neumann-Morgenstern utility function) of income are estimated in two states; when being paralyzed and when not being paralyzed. Experimental choices between imagined lotteries, where the outcome includes both income and disability status, are used. This allows for estimation of the ratio of the individual’s marginal utility of income when being paralyzed and when not being paralyzed, the Relative Marginal Utility of Income when Disabled (RMUID). The median RMUID is estimated to between 1.33 and 2. It is extremely (at the 0.005 % level) statistically significant higher than one. Individuals with personal experience of mobility impairment and of university studies, and voters for the Left Block and the Liberal Party, have higher RMUID than others. The results have implications for the optimal level of insurance and for the question of whether we should use distributional weights in cost-benefit analysis.<p> |
| Keywords: | Disability; Mobility impairment; Marginal utility; Hypothetical lotteries; Risk |
| JEL: | D10 D60 D63 I10 I30 |
| Date: | 2007–11–21 |
| URL: | http://d.repec.org/n?u=RePEc:hhs:gunwpe:0276&r=upt |
| By: | Gallice, Andrea |
| Abstract: | We investigate how the assumption that individuals are characterized by some recent forms of behavioural preferences changes the analysis of an otherwise classical welfare problem, namely the optimal allocation of a scarce resource among a finite number of claimants. We consider two preference specifications: inequity aversion and reference dependence. In the latter case we also study the implications of the claimants displaying a self-serving bias when setting their reference point. Using standard welfare criteria, we compute the optimal allocations that a benevolent social planner should implement in the various scenarios. Results are often remarkably different with respect to traditional (i.e., rational preferences) analysis. We discuss the policy implications and the role of a social planner. |
| Keywords: | inequity aversion; optimum allocation; reference dependence; self-serving bias; social welfare |
| JEL: | D01 D61 |
| Date: | 2007–11 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:6572&r=upt |
| By: | Marc Oliver Rieger (ETH Zurich, Department of Mathematics); Mei Wang (University of Zurich, ISB) |
| Abstract: | We extend the original form of Prospect Theory by Kahneman and Tversky from finite lotteries to arbitrary probability distributions, thus paving the way for applications in economics and finance. Moreover, we suggest a method how to incorporate a crucial step of the “editing phase” into Prospect Theory and to remove in this way the discontinuity of the original model. |
| Keywords: | Prospect Theory, Cumulative Prospect Theory, continuity, probability weighting, first-order stochastic dominance. |
| JEL: | D81 |
| Date: | 2007–03 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp0730&r=upt |
| By: | Hill, Brian |
| Abstract: | The phenomenon of adaptive preferences – sometimes also known under the name of sour grapes – has long caused a stir in Social Theory. In this paper, the precise problem posed by adaptive preferences, as seen from the point of view of a theoretician who intends to model or understand the phenomenon, will be clarified, and three models of the phenomenon will be presented and compared. The general intention of the article is to sound out some of the wider consequences of the phenomenon for the project of modelling and understanding the relationship between decisions taken in different situations. Difficulties which arise when several decisions and several situations are involved shall be discussed, and an approach to these difficulties shall be suggested. |
| Keywords: | Adaptive preferences; preference change; belief change; decision theory; belief and utility elicitation; representation theorems. |
| JEL: | B49 D89 |
| Date: | 2007–04–13 |
| URL: | http://d.repec.org/n?u=RePEc:ebg:heccah:0873&r=upt |