
on Utility Models and Prospect Theory 
Issue of 2011‒04‒09
twentyone papers chosen by Alexander Harin Modern University for the Humanities 
By:  kevin dowd; john cotter 
Abstract:  Spectral risk measures are attractive risk measures as they allow the user to obtain risk measures that reflect their riskaversion functions. To date there has been very little guidance on the choice of riskaversion functions underlying spectral risk measures. This paper addresses this issue by examining two popular risk aversion functions, based on exponential and power utility functions respectively. We find that the former yields spectral risk measures with nice intuitive properties, but the latter yields spectral risk measures that can have perverse properties. More work therefore needs to be done before we can be sure that arbitrary but respectable utility functions will always yield 'wellbehaved' spectral risk measures. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5668&r=upt 
By:  John Cotter; Jim Hanly 
Abstract:  Risk aversion is a key element of utility maximizing hedge strategies; however, it has typically been assigned an arbitrary value in the literature. This paper instead applies a GARCHinMean (GARCHM) model to estimate a timevarying measure of risk aversion that is based on the observed risk preferences of energy hedging market participants. The resulting estimates are applied to derive explicit risk aversion based optimal hedge strategies for both short and long hedgers. Outofsample results are also presented based on a unique approach that allows us to forecast risk aversion, thereby estimating hedge strategies that address the potential future needs of energy hedgers. We find that the risk aversion based hedges differ significantly from simpler OLS hedges. When implemented insample, risk aversion hedges for short hedgers outperform the OLS hedge ratio in a utility based comparison. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5968&r=upt 
By:  Emmanuelle GABILLON (GREThA, CNRS, UMR 5113) 
Abstract:  Following Quiguin (1994), we propose a general model of preferences that accounts for individuals\' regret concerns. By confronting the commonlyaccepted additive and multiplicative regret utility functions to this model, we establish certain characteristics that these utility functions require to be in conformity with our preferences model. Equally, as regret is intrinsically related to the concept of information about the foregone alternatives, we generalize our framework so that it can accomodate any information structure. We show that the less informative that structure is, the higher the utility of a regretful individual. This result means that an individual prefers not to be exposed to ex post information about the foregone alternatives. We also focus on information value, and consider two cases. That of flexibility, where information arrives before the choice and can be used to determine the optimal strategy; that of nonflexibility, where information arrives after the choice. We show that information value is negative when there is no flexibility, and that it can also be negative when there is flexibility. 
Keywords:  , information, choice under uncertainty, bivariate risk aversion 
JEL:  D81 D82 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:grt:wpegrt:201115&r=upt 
By:  John Cotter; Jim Hanly 
Abstract:  A key issue in the estimation of energy hedges is the hedgers' attitude towards risk which is encapsulated in the form of the hedgers' utility function. However, the literature typically uses only one form of utility function such as the quadratic when estimating hedges. This paper addresses this issue by estimating and applying energy market based risk aversion to commonly applied utility functions including log, exponential and quadratic, and we incorporate these in our hedging frameworks. We find significant differences in the optimal hedge strategies based on the utility function chosen. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5973&r=upt 
By:  Cherchye, L.J.H.; Demuynck, T.; Rock, B. de (Tilburg University, Center for Economic Research) 
Abstract:  We provide a revealed preference analysis of the transferable utility hypothesis, which is widely used in economic models. First, we establish revealed preference conditions that must be satisfied for observed group behavior to be consistent with Pareto efficiency under transferable utility. Next, we show that these conditions are easily testable by means of integer programming methods. The tests are entirely nonparametric, which makes them robust with respect to specification errors. Finally, we demonstrate the practical usefulness of our conditions by means of an application to Spanish consumption data. To the best of our knowledge, this is the first empirical test of the transferable utility hypothesis. 
Keywords:  transferable utility hypothesis;generalized quasilinearity;nonparamet ric tests;revealed preferences. 
JEL:  C14 D11 D12 D13 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:dgr:kubcen:2011018&r=upt 
By:  Eike B. Kroll (Institute of Economic Theory and Statistics (ETS), Karlsruhe Institute of Technology); Judith N. Trarbach (Faculty of Economics and Management, OttovonGuericke University Magdeburg); Bodo Vogt (Faculty of Economics and Management, OttovonGuericke University Magdeburg) 
Abstract:  The QALY concept is the commonly used approach in research to evaluate the efficiency of therapies in cost utility analysis. We investigate the risk neutrality assumption for time of the QALY concept: can time be included as a linear factor? Various studies show that this assumption does not hold empirically. However, the results are based on hypothetical questionnaires rather than decisions with real consequences. Experimental economists argue that experiments are necessary to avoid hypothetical bias. Our study provides the first experimental analysis of health related decision making. Using the cold pressor test we can analyze decisions when subjects face real consequences. Analog to the hypothetical studies, our experimental results of real decisions provide no linear time preferences. In conclusion, the QALY concept needs to be modified by a weighting factor for time. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:mag:wpaper:110006&r=upt 
By:  Laeven, R.J.A.; Stadje, M.A. (Tilburg University, Center for Economic Research) 
Abstract:  We introduce two subclasses of convex measures of risk, referred to as entropy coherent and entropy convex measures of risk. We prove that convex, entropy convex and entropy coherent measures of risk emerge as certainty equivalents under variational, homothetic and multiple priors preferences, respectively, upon requiring the certainty equivalents to be translation invariant. In addition, we study the properties of entropy coherent and entropy convex measures of risk, derive their dual conjugate function, and prove their distribution invariant representation. Some financial applications and examples of entropy coherent and entropy convex measures of risk are also investigated. 
Keywords:  Multiple priors;Variational and homothetic preferences;Robustness;Convex risk measures;Exponential utility;Relative entropy;Translation invariance;Convexity;Indifference valuation. 
JEL:  D81 G10 G20 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:dgr:kubcen:2011031&r=upt 
By:  Kevin Dowd; John Cotter; Ghulam Sorwar 
Abstract:  Spectral risk measures (SRMs) are risk measures that take account of user riskaversion, but to date there has been little guidance on the choice of utility function underlying them. This paper addresses this issue by examining alternative approaches based on exponential and power utility functions. A number of problems are identified with both types of spectral risk measure. The general lesson is that users of spectral risk measures must be careful to select utility functions that fit the features of the particular problems they are dealing with, and should be especially careful when using power SRMs. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5674&r=upt 
By:  Kevin Dowd; John Cotter 
Abstract:  Spectral risk measures are attractive risk measures as they allow the user to obtain risk measures that reflect their subjective riskaversion. This paper examines spectral risk measures based on an exponential utility function, and finds that these risk measures have nice intuitive properties. It also discusses how they can be estimated using numerical quadrature methods, and how confidence intervals for them can be estimated using a parametric bootstrap. Illustrative results suggest that estimated exponential spectral risk measures obtained using such methods are quite precise in the presence of normally distributed losses. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5409&r=upt 
By:  James C. Cox; Vjollca Sadiraj; Ulrich Schmidt 
Abstract:  Experiments on choice under risk typically involve multiple decisions by individual subjects. The choice of mechanism for selecting decision(s) for payoff is an essential design feature that is often driven by appeal to the isolation hypothesis or the independence axiom. We report two experiments with 710 subjects. Experiment 1 provides the first simple test of the isolation hypothesis. Experiment 2 is a crossed design with six payoff mechanisms and five lottery pairs that can elicit four paradoxes for the independence axiom and dual independence axiom. The crossed design discriminates between: (a) behavioral deviations from postulated properties of payoff mechanisms; and (b) behavioral deviations from theoretical implications of alternative decision theories. Experiment 2 provides tests of the isolation hypothesis and four paradoxes. It also provides data for tests for portfolio effect, wealth effect, reduction, adding up, and crosstask contamination. Data from Experiment 2 suggest that a new mechanism introduced herein may be less biased than random selection of one decision for payoff. 
JEL:  C91 D81 
Date:  2011–04 
URL:  http://d.repec.org/n?u=RePEc:exc:wpaper:201107&r=upt 
By:  Simone CerreiaVioglio; Fabio Maccheroni; Massimo Marinacci; Luigi Montrucchio 
Abstract:  Starting with the seminal paper of Gilboa and Schmeidler (1989) an analogy between the maxmin approach of Decision Theory under Ambiguity and the minimax approach of Robust Statistics  e.g. Huber and Strassen (1973)  has been hinted at. The present paper formally clarifies this relation by showing the conditions under which the two approaches are actually equivalent. 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:igi:igierp:382&r=upt 
By:  Flåm, Sjur Didrik (University of Bergen, Department of Economics) 
Abstract:  Abstract. Exchange of risks is considered here as a transferableutility, cooperative game, featuring risk averse players. Like in competitive equilibrium, a core solution is determined by shadow prices on statedependent claims. And like in finance, no risk can properly be priced only in terms of its marginal distribution. Pricing rather depends on the pooled risk and on the convolution of individual preferences. The paper elaborates on these features, placing emphasis on the role of prices and incompleteness. Some novelties come by bringing questions about existence, computation and uniqueness of solutions to revolve around standard Lagrangian duality. Especially outlined is how repeated bilateral trade may bring about a pricesupported core allocation. 
Keywords:  Keywords: cooperative game; transferable utility; core; risks; mutual insurance; contingent prices; bilateral exchange; supergradients; stochastic approximation. 
JEL:  C71 D52 G12 
Date:  2011–04–01 
URL:  http://d.repec.org/n?u=RePEc:hhs:bergec:2006_009&r=upt 
By:  Carolin E. Pflueger; Luis M. Viceira 
Abstract:  This paper empirically analyzes the Expectations Hypothesis (EH) in inflationindexed (or real) bonds and in nominal bonds in the US and in the UK. We strongly reject the EH in inflationindexed bonds, and also confirm and update the existing evidence rejecting the EH in nominal bonds. This rejection implies that the risk premium on both real and nominal bonds varies predictably over time. We also find strong evidence that the spread between the nominal and the real bond risk premium, or the breakeven inflation risk premium, also varies over time. We argue that the time variation in real bond risk premia mostly likely reflects both a changing real interest rate risk premium and a changing liquidity risk premium, and that the variability in the nominal bond risk premia reflects a changing inflation risk premium. We estimate significant time series variability in the magnitude and sign of bond risk premia. 
JEL:  G12 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:16903&r=upt 
By:  Johannes Temme 
Abstract:  Consider power utility maximization of terminal wealth in a 1dimensional continuoustime exponential Levy model with finite time horizon. We discretize the model by restricting portfolio adjustments to an equidistant discrete time grid. Under minimal assumptions we prove convergence of the optimal discretetime strategies to the continuoustime counterpart. In addition, we provide and compare qualitative properties of the discretetime and continuoustime optimizers. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5575&r=upt 
By:  John Cotter; Kevin Dowd 
Abstract:  This paper applies the ExtremeValue (EV) Generalised Pareto distribution to the extreme tails of the return distributions for the S&P500, FT100, DAX, Hang Seng, and Nikkei225 futures contracts. It then uses tail estimators from these contracts to estimate spectral risk measures, which are coherent risk measures that reflect a user's riskaversion function. It compares these to VaR and Expected Shortfall (ES) risk measures, and compares the precision of their estimators. It also discusses the usefulness of these risk measures in the context of clearinghouses setting initial margin requirements, and compares these to the SPAN measures typically used. Keywords: Spectral risk measures, Expected Shortfall, Value at Risk, Extreme Value 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5653&r=upt 
By:  Gabrielle Demange (PSE  ParisJourdan Sciences Economiques  CNRS : UMR8545  Ecole des Hautes Etudes en Sciences Sociales (EHESS)  Ecole des Ponts ParisTech  Ecole Normale Supérieure de Paris  ENS Paris  INRA, EEPPSE  Ecole d'Économie de Paris  Paris School of Economics  Ecole d'Économie de Paris) 
Abstract:  This paper presents results on the transitivity of the majority relation and the existence of a median representative ordering. Building on the notion of intermediate preferences indexed by a median graph, the analysis extends wellknown results obtained when the underlying graph is a line. In contrast with other types of restrictions such as singlepeakedness, intermediate preferences allow for a clear distinction between restrictions on the set of preferences characteristics and those on the set of alternatives. 
Keywords:  majority rule ; median graph ; tree ; Condorcet winner ; intermediate preferences 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:hal:psewpa:halshs00581310&r=upt 
By:  Elena Di Bernadino (SAF  Laboratoire de Sciences Actuarielle et Financière  Université Claude Bernard  Lyon I : EA2429); Thomas Laloë (JAD  Laboratoire Jean Alexandre Dieudonné  CNRS : UMR6621  Université de Nice SophiaAntipolis); Véronique MaumeDeschamps (SAF  Laboratoire de Sciences Actuarielle et Financière  Université Claude Bernard  Lyon I : EA2429); Clémentine Prieur (INRIA RhôneAlpes / LJK Laboratoire Jean Kuntzmann  MOISE  CNRS : UMR5224  INRIA  Laboratoire Jean Kuntzmann  Université Joseph Fourier  Grenoble I  Institut Polytechnique de Grenoble, (Méthodes d'Analyse Stochastique des Codes et Traitements Numériques)  GdR MASCOTNUM  CNRS : GDR3179) 
Abstract:  This paper deals with the problem of estimating the level sets of an unknown distribution function $F$. A plugin approach is followed. That is, given a consistent estimator $F_n$ of $F$, we estimate the level sets of $F$ by the level sets of $F_n$. In our setting no compactness property is a priori required for the level sets to estimate. We state consistency results with respect to the Hausdorff distance and the volume of the symmetric difference. Our results are motivated by applications in multivariate risk theory. In this sense we also present simulated and real examples which illustrate our theoretical results. 
Keywords:  Level sets ; Distribution function ; Plugin estimation ; Hausdorff distance ; Conditional Tail Expectation 
Date:  2011–03–28 
URL:  http://d.repec.org/n?u=RePEc:hal:wpaper:hal00580624&r=upt 
By:  Matthias Uhl (Max Planck Institute of Economics, IMPRS "Uncertainty", Jena, Germany) 
Abstract:  Loewenstein (1996, 2005) identifies an intrapersonal empathy gap. In the respective experiments, subjects make choices with delayed consequences. When entering the state where these consequences would unfold, they get the possibility to revise their initial choice. Revisions are more substantial when these two choices are made in different emotional states. The concept of the empathy gap suggests that the initial choice represents a misprediction of future preferences. However, it might alternatively be based on a well understood disagreement with future preferences. In this sense, people would like to add: "But don't ask me again!" To disentangle both explanations, we induce two different emotional states in each subject and offer a selfcommitment device in the first state. In one condition, subjects move from a "cold" state of reflection to a "hot" state of impulsiveness. In the other condition, this order is reversed. We find evidence for the hottocold empathy gap, but not for the coldtohot empathy gap when subjects can selfcommit to their initial choice. 
Keywords:  Intrapersonal empathy gap, selfcommitment, intrapersonal conflict, naiveté, sophistication 
JEL:  C90 
Date:  2011–04–04 
URL:  http://d.repec.org/n?u=RePEc:jrp:jrpwrp:2011019&r=upt 
By:  John Cotter; Kevin Dowd 
Abstract:  This paper applies an AR(1)GARCH (1, 1) process to detail the conditional distributions of the return distributions for the S&P500, FT100, DAX, Hang Seng, and Nikkei225 futures contracts. It then uses the conditional distribution for these contracts to estimate spectral risk measures, which are coherent risk measures that reflect a user's riskaversion function. It compares these to more familiar VaR and Expected Shortfall (ES) measures of risk, and also compares the precision and discusses the relative usefulness of each of these risk measures in setting variation margins that incorporate timevarying market conditions. The goodness of fit of the model is confirmed by a variety of backtests. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5408&r=upt 
By:  Kevin Dowd; John Cotter 
Abstract:  This paper examines the precision of estimators of QuantileBased Risk Measures (Value at Risk, Expected Shortfall, Spectral Risk Measures). It first addresses the question of how to estimate the precision of these estimators, and proposes a Monte Carlo method that is free of some of the limitations of existing approaches. It then investigates the distribution of risk estimators, and presents simulation results suggesting that the common practice of relying on asymptotic normality results might be unreliable with the sample sizes commonly available to them. Finally, it investigates the relationship between the precision of different risk estimators and the distribution of underlying losses (or returns), and yields a number of useful conclusions. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5665&r=upt 
By:  John Cotter; Kevin Dowd; Wyn Morgan 
Abstract:  Risk is an inherent feature of agricultural production and marketing and accurate measurement of it helps inform more efficient use of resources. This paper examines three tail quantilebased risk measures applied to the estimation of extreme agricultural financial risk for corn and soybean production in the US: Value at Risk (VaR), Expected Shortfall (ES) and Spectral Risk Measures (SRMs). We use Extreme Value Theory (EVT) to model the tail returns and present results for these three different risk measures using agricultural futures market data. We compare the estimated risk measures in terms of their size and precision, and find that they are all considerably higher than normal estimates; they are also quite uncertain, and become more uncertain as the risks involved become more extreme. 
Date:  2011–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1103.5962&r=upt 