|
on Utility Models and Prospect Theory |
| By: | Hui Chen (MIT Sloan School of Management); Nengjiu Ju (Department of Finance, the Hong Kong University of Science and Technology); Jianjun Miao (Department of Economics, Boston University) |
| Abstract: | We study an investor's optimal consumption and portfolio choice problem when he confronts with two possibly misspecified submodels of stock returns: one with IID returns and the other with predictability. We adopt a generalized recursive ambiguity model to accommodate the investor's aversion to model uncertainty. The investor deals with specification doubts by slanting his beliefs about submodels of returns pessimistically, causing his investment strategy to be more conservative than the Bayesian strategy. This effect is large for extreme values of the predictive variable. Unlike in the Bayesian framework, model uncertainty induces a hedging demand, which may cause the investor to decrease his stock allocations sharply and then increase with his prior probability of IID returns. Adopting suboptimal investment strategies by ignoring model uncertainty can lead to sizable welfare costs. |
| Keywords: | generalized recursive ambiguity utility, ambiguity aversion, model uncertainty, learning, portfolio choice, robustness, return predictability |
| JEL: | D81 D83 G11 E21 |
| Date: | 2008–09 |
| URL: | http://d.repec.org/n?u=RePEc:bos:iedwpr:dp-179&r=upt |
| By: | Hui Chen (MIT Sloan School of Management); Jianjun Miao (Department of Economics, Boston University); Neng Wang (Columbia Business School and National Bureau of Economic Research) |
| Abstract: | Entrepreneurs face significant non-diversifiable business risks. We build a dynamic incompletemarkets model of entrepreneurial finance to demonstrate the important implications of nondiversifiable risks for entrepreneurs’ interdependent consumption, portfolio allocation, financing, investment, and business exit decisions. The optimal capital structure is determined by a generalized tradeoff model where leverage via risky non-recourse debt provides significant diversification benefits. More risk-averse entrepreneurs default earlier, but also choose higher leverage, even though leverage makes his equity more risky. Non-diversified entrepreneurs demand both systematic and idiosyncratic risk premium. Cash-out option and external equity further improve diversification and raise the entrepreneur’s valuation of the firm. Finally, entrepreneurial risk aversion can overturn the risk-shifting incentives induced by risky debt. |
| Keywords: | Default, diversification benefits, entrepreneurial risk aversion, incomplete markets, private equity premium, hedging, capital structure, cash-out option, precautionary saving |
| JEL: | G11 G31 E2 |
| Date: | 2009–03 |
| URL: | http://d.repec.org/n?u=RePEc:bos:iedwpr:dp-180&r=upt |
| By: | Borghans Lex; Golsteyn Bart; Heckman James; Meijers Huub (ROA rm) |
| Abstract: | This paper demonstrates gender differences in risk aversion and ambiguityaversion. It also contributes to a growing literature relating economic preferenceparameters to psychological measures by asking whether variations in preferenceparameters among persons, and in particular across genders, can be accounted forby differences in personality traits and traits of cognition. Women are more riskaverse than men. Over an initial range, women require no further compensationfor the introduction of ambiguity but men do. At greater levels of ambiguity,women have the same marginal distaste for increased ambiguity as men.Psychological variables account for some of the interpersonal variation in riskaversion. They explain none of the differences in ambiguity. |
| Keywords: | education, training and the labour market; |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:dgr:umaror:2009006&r=upt |
| By: | Pierre-Andre Chiappori; Amit Gandhi; Bernard Salanie; Francois Salanie |
| Date: | 2009–05 |
| URL: | http://d.repec.org/n?u=RePEc:ler:wpaper:09.11.287&r=upt |
| By: | François Gourio (Boston University, Department of Economics) |
| Abstract: | This paper studies whether the Rietz–Barro “disaster” model, extended for a time-varying probability of disaster, can match the empirical evidence on predictability of stock returns. It is shown that when utility is CRRA, the model cannot replicate this evidence, regardless of parameter values. This motivates extending the disaster model to allow for Epstein–Zin utility. Analytical results show that when the probability of disaster is i.i.d., the model with Epstein–Zin utility can match the evidence on predictability qualitatively if the intertemporal elasticity of substitution is greater than unity. The case of a persistent probability of disaster is studied numerically, with partial success. |
| Keywords: | Rare events, Jumps, Disasters, Equity premium, Return predictability |
| JEL: | E43 E44 G11 G12 |
| Date: | 2008–01 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2008-016&r=upt |
| By: | Andrea Gallice |
| Abstract: | A lowest unique bid auction allocates a good to the agent who submits the lowest bid that is not matched by any other bid. This peculiar auction format is becoming increasingly popular over the Internet. We show that when all the bidders are rational such a selling mechanism can lead to positive profits only if there is a large mismatch between the auctioneer's and the bidders' valuation. On the contrary, the auction becomes highly lucrative if at least some bidders are myopic. In this second case, we analyze the key role played by the existence of some private signals that the seller sends to the bidders about the status of their bids. Data about actual auctions confirm the profitability of the mechanism and the limited rationality of the bidders. |
| Keywords: | Lowest unique bid auctions; Signals; Bounded rationality. |
| JEL: | D44 C72 D82 |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:cca:wpaper:112&r=upt |
| By: | Elchanan Ben-Porath (Department of Economics and Center for Rationality, Hebrew University); Barton L. Lipman (Department of Economics, Boston University) |
| Abstract: | We extend implementation theory by allowing the social choice function to depend on more than just the prole of preferences of the agents and by allowing agents to support their statements with hard evidence. We show that a simple condition on the evidence structure which is necessary for the implementation of a social choice function f when the preferences of the agents are state independent is also sufficient for implementation for any preferences (including state dependent) if the social planner can perform small monetary transfers and there are at least three players. If transfers can be large, f can be implemented in a game with perfect information when there are at least two players under an additional boundedness assumption. In both cases, transfers only occur off the equilibrium path. Finally, in the special but important case of allocation problems, under weak conditions, f can be implemented in a perfect information game with at least two players and no transfers. In all cases, the use of evidence enables implementation which is robust in the sense that the social planner needs very little information about the preferences, beliefs, and evidence of the agents and the agents need little information about each others' preferences. |
| Date: | 2009–04 |
| URL: | http://d.repec.org/n?u=RePEc:bos:wpaper:wp2009-002&r=upt |
| By: | Bruno Feunou; Jean-Sébastien Fontaine; Roméo Tedongap |
| Abstract: | We introduce the Homoscedastic Gamma [HG] model where the distribution of returns is characterized by its mean, variance and an independent skewness parameter under both measures. The model predicts that the spread between historical and risk-neutral volatilities is a function of the risk premium and of skewness. In fact, the equity premium is twice the ratio of the volatility spread to skewness. We measure skewness from option prices and test these predictions. We find that conditioning on skewness increases the predictive power of the volatility spread and that coefficient estimates accord with theory. In short, the data do not reject the model's implications for the equity premium. We also check the model's implications for option pricing and show that the information content of skewness leads to improved in-sample and out-of-sample pricing performances as well as improved hedging performances. Our results imply that expanding around the Gaussian density is restrictive and does not offer sufficient flexibility to match the skewness and kurtosis implicit in option data. Finally, we document the term structure of option-implied volatility, skewness and kurtosis and find that time-dependence in returns has a greater impact on skewness. |
| Keywords: | Financial markets |
| JEL: | G12 G13 |
| Date: | 2009 |
| URL: | http://d.repec.org/n?u=RePEc:bca:bocawp:09-20&r=upt |