|
on Utility Models and Prospect Theory |
| By: | Johanna Etner; Sandrine Spaeter |
| Abstract: | In this paper, we analyze the choice of primary prevention made by individuals who bear a risk of being in bad health and an additive risk (of complications) that occurs after a disease has been diagnosed. By considering a two argument utility (depending on wealth and health), we show that the presence of a well-known (no ambiguity) additive risk of complications induces more investment in primary prevention by a risk-averse agent only if her preferences does not display some cross prudence in wealth (u122 < 0). If there is some ambiguity on the e¤ective probability of complication, an increase in ambiguity aversion increases prevention if the agent is a correlation lover (u12 > 0). We also show that full (partial) insurance can be optimal even if insurance premia are loaded (fair). These results hold with and without prevention and the individuals attitudes toward correlation help explain the impact of ambiguity on the optimal individual decisions. |
| Keywords: | health; utility; ambiguity; prevention; insurance. |
| JEL: | D81 I19 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:ulp:sbbeta:2010-08&r=upt |
| By: | Gill, David; Prowse, Victoria |
| Abstract: | We develop a novel computerized real effort task, based on moving sliders across a screen, to test experimentally whether agents are disappointment averse when they compete in a real effort sequential-move tournament. We predict that a disappointment averse agent, who is loss averse around her endogenous choice-acclimating expectations-based reference point, responds negatively to her rival's effort. We find significant evidence for this discouragement effect, and use the Method of Simulated Moments to estimate the strength of disappointment aversion on average and the heterogeneity in disappointment aversion across the population. <br><br> Keynames; Disappointment aversion; Loss aversion; Reference-dependent preferences; Reference point adjustment; Expectations; Tournament; Real effort experiment; Slider task. <br><br> JEL Classification: C91; D03. |
| Date: | 2010–03–01 |
| URL: | http://d.repec.org/n?u=RePEc:stn:sotoec:1006&r=upt |
| By: | Anat Bracha (Federal Reserve Bank of Boston); Donald J. Brown (Department of Economics, Yale University) |
| Abstract: | Optimism-bias is inconsistent with the independence of decision weights and payoffs found in models of choice under risk, such as expected utility theory and prospect theory. Hence, to explain the evidence suggesting that agents are optimistically biased, we propose an alternative model of risky choice, affective decision-making, where decision weights -- which we label affective or perceived risk -- are endogenized. Affective decision making (ADM) is a strategic model of choice under risk, where we posit two cognitive processes: the "rational" and the "emotional" processes. The two processes interact in a simultaneous-move intrapersonal potential game, and observed choice is the result of a pure strategy Nash equilibrium in this potential game. We show that regular ADM potential games have an odd number of locally unique pure strategy Nash equilibria, and demonstrate this finding for affective decision making in insurance markets. We prove that ADM potential games are refutable, by axiomatizing the ADM potential maximizers. |
| Keywords: | Affective decision-making, Optimism-bias, ADM potential games, Demand for insurance |
| JEL: | D01 D81 G22 |
| Date: | 2010–03 |
| URL: | http://d.repec.org/n?u=RePEc:cwl:cwldpp:1759&r=upt |
| By: | David German |
| Abstract: | We review the utility-based valuation method for pricing derivative securities in incomplete markets. In particular, we review the practical approach to the utility-based pricing by the means of computing the first order expansion of marginal utility-based prices with respect to a small number of random endowments. |
| Date: | 2010–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1003.5712&r=upt |
| By: | Thomas Lim (PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII); Marie-Claire Quenez (PMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris-Diderot - Paris VII) |
| Abstract: | In this paper, we consider a financial market with assets exposed to some risks inducing jumps in the asset prices, and which can still be traded after default times. We use a default-intensity modeling approach, and address in this incomplete market context the problem of maximization of expected utility from terminal wealth for logarithmic, power and exponential utility functions. We study this problem as a stochastic control problem both under full and partial information. Our contribution consists in showing that the optimal strategy can be obtained by a direct approach for the logarithmic utility function, and the value function for the power utility function can be determined as the minimal solution of a backward stochastic differential equation. For the partial information case, we show how the problem can be divided into two problems: a filtering problem and an optimization problem. We also study the indifference pricing approach to evaluate the price of a contingent claim in an incomplete market and the information price for an agent with insider information. |
| Keywords: | Optimal investment, default time, default intensity, filtering, dynamic programming principle, backward stochastic differential equation, indifference price, information pricing, logarithmic utility, power utility, exponential utility. |
| Date: | 2010–03–29 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-00468072_v1&r=upt |
| By: | Kontek, Krzysztof |
| Abstract: | This paper deals with estimating data from experiments determining lottery certainty equivalents. The paper presents the parametric and nonparametric results of the least squares (mean), quantile (including median) and mode estimations. The examined data are found to be positively skewed for low probabilities and negatively skewed for high probabilities. This observation leads to the striking conclusion that lottery valuations are only nonlinearly related to probability when means are considered. Such nonlinearity is not confirmed by the mode estimator in which case the most likely lottery valuations are close to their expected values. This means that the most likely behavior of a group is fully rational. This conclusion is a significant departure from one of the fundamental results concerning lottery experiments presented so far. |
| Keywords: | Lottery experiments; Least Squares; Quantile; Median; and Mode Estimators; Nonparametric and Parametric Estimators; Relative Utility Function; Prospect Theory. |
| JEL: | C51 D81 C91 C13 C14 C81 C21 C01 D87 |
| Date: | 2010–03–30 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:21758&r=upt |
| By: | Ludger Schuknecht (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.); Jürgen von Hagen (University of Bonn, Indiana University Kelley School of Business, and CEPR.); Guido Wolswijk (European Central Bank, Kaiserstrasse 29, 60311 Frankfurt am Main, Germany.) |
| Abstract: | This note looks at US$ and DM/Euro denominated government bond spreads relative to US and German benchmark bonds before and after the start of the current financial crisis. The study finds, first, that bond yield spreads before and during the crisis can largely be explained on the basis of economic principles. Second, markets penalise fiscal imbalances much more strongly after the Lehman default in September 2008 than before. There is also a significant increase in the spread on non-benchmark bonds due to higher general risk aversion, and German bonds obtained a safe-haven investment status similar to that of the US which they did not have before the crisis. These findings underpin the need for achieving sound fiscal positions in good times and complying with the Stability and Growth Pact. JEL Classification: E43, E62, H63, H74. |
| Keywords: | interest rates, fiscal policy, government debt, crisis, risk aversion, safe haven. |
| Date: | 2010–02 |
| URL: | http://d.repec.org/n?u=RePEc:ecb:ecbwps:20101152&r=upt |
| By: | Christopher J. Neely; David E. Rapach; Jun Tu; Guofu Zhou |
| Abstract: | This paper analyzes the ability of both economic variables and moving-average rules to forecast the monthly U.S. equity premium using out-of-sample tests for 1960?2008. Both approaches provide statistically and economically significant out-of-sample forecasting gains, which are concentrated in U.S. business-cycle recessions. Nevertheless, economic variables and moving-average rules capture different sources of equity premium fluctuations: moving average rules detect the decline in the average equity premium early in recessions, while economic variables more readily pick up the rise in the average equity premium later in recessions. When we simulate data with a habit-formation model characterized by time-varying return volatility and risk aversion relating to business-cycle fluctuations, we find that this model cannot fully account for the out-of-sample forecasting gains in the actual data evidenced by economic variables and moving-average rules. |
| Keywords: | Forecasting ; Stocks |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedlwp:2010-008&r=upt |
| By: | Roland Kirstein (Faculty of Economics and Management, Otto-von-Guericke-University); Georg v. Wangenheim (University of Kassel, Faculty of Law) |
| Abstract: | The Condorcet Jury Theorem is derived from the implicit assumption that jury members only commit one type of error. If the probability of this error is smaller than 0.5, then group decisions are better than those of individual members. In binary decision situations, however, two types of error may occur, the probabilities of which are independent of each other. Taking this into account leads to a generalization of the theorem. Under this generalization, situations exists in which the probability of error is greater than 0.5 but the jury decision generates a higher expected welfare than an individual decision. Conversely, even if the probability of error is lower than 0.5 it is possible that individual decisions are superior. |
| Keywords: | Group decisions, judicial, imperfect decision-making |
| JEL: | D71 K40 L22 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:mar:magkse:201011&r=upt |
| By: | Rowena Pecchenino (Economics,Finance and Accounting,National University of Ireland, Maynooth); |
| Abstract: | We make choices to achieve an objective. The objective is defined by an individual’s preferences. Subject to constraints, the objective is approached or achieved. Is this a good characterization of life? To answer this question we weaken one of the most basic assumptions of economics: individuals know their preferences. Instead we assume that an individual’s preferences are shaped and reshaped by his environment, experiences, expectations, and by exogenous events. In this model of individual self-discovery, preferences emerge, evolve, and change. These redefinitions change the future course of the individual’s life and reinterpret his past. They characterize a life lived. |
| Keywords: | Identity, Preferences, Choice, Life |
| JEL: | D01 |
| Date: | 2010 |
| URL: | http://d.repec.org/n?u=RePEc:may:mayecw:n205-10.pdf&r=upt |
| By: | Francesco Audrino; Fulvio Corsi; Kameliya Filipova |
| Abstract: | We propose a simple but effective estimation procedure to extract the level and the volatility dynamics of a latent macroeconomic factor from a panel of observable indicators. Our approach is based on a multivariate conditionally heteroskedastic exact factor model that can take into account the heteroskedasticity feature shown by most macroeconomic variables and relies on an iterated Kalman filter procedure. In simulations we show the unbiasedness of the proposed estimator and its superiority to different approaches introduced in the literature. Simulation results are confirmed in applications to real inflation data with the goal of forecasting long-term bond risk premia. Moreover, we find that the extracted level and conditional variance of the latent factor for inflation are strongly related to NBER business cycles. |
| Keywords: | Macroeconomic variables; Exact factor model; Kalman filter; Heteroskedasticity; Forecasting bond risk premia; Inflation measures; Business cycles |
| JEL: | C13 C33 C53 C82 E31 E47 |
| Date: | 2010–03 |
| URL: | http://d.repec.org/n?u=RePEc:usg:dp2010:2010-09&r=upt |