nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2011‒04‒09
twenty-one papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Spectral Risk Measures and the Choice of Risk Aversion Function By kevin dowd; john cotter
  2. Time Varying Risk Aversion: An Application to Energy Hedging By John Cotter; Jim Hanly
  3. A Theory of Regret and Information By Emmanuelle GABILLON (GREThA, CNRS, UMR 5113)
  4. A Utility Based Approach to Energy Hedging By John Cotter; Jim Hanly
  5. Is Utility Transferable? A Revealed Preference Analysis By Cherchye, L.J.H.; Demuynck, T.; Rock, B. de
  6. Determining risk preferences for pain By Eike B. Kroll; Judith N. Trarbach; Bodo Vogt
  7. Entropy Coherent and Entropy Convex Measures of Risk By Laeven, R.J.A.; Stadje, M.A.
  8. Spectral Risk Measures: Properties and Limitations By Kevin Dowd; John Cotter; Ghulam Sorwar
  9. Exponential Spectral Risk Measures By Kevin Dowd; John Cotter
  10. Paradoxes and Mechanisms for Choice under Risk By James C. Cox; Vjollca Sadiraj; Ulrich Schmidt
  11. Ambiguity and Robust Statistics By Simone Cerreia-Vioglio; Fabio Maccheroni; Massimo Marinacci; Luigi Montrucchio
  12. Pooling, Pricing and Trading of Risks By Flåm, Sjur Didrik
  13. Inflation-Indexed Bonds and the Expectations Hypothesis By Carolin E. Pflueger; Luis M. Viceira
  14. Power Utility Maximization in Discrete-Time and Continuous-Time Exponential Levy Models By Johannes Temme
  15. Extreme Spectral Risk Measures: An Application to Futures Clearinghouse Margin Requirements By John Cotter; Kevin Dowd
  16. Majority relation and median representative ordering By Gabrielle Demange
  17. Plug-in estimation of level sets in a non-compact setting with applications in multivariate risk theory By Elena Di Bernadino; Thomas Laloë; Véronique Maume-Deschamps; Clémentine Prieur
  18. Challenging the Intrapersonal Empathy Gap An Experiment with Self-Commitment Power By Matthias Uhl
  19. Spectral Risk Measures with an Application to Futures Clearinghouse Variation Margin Requirements By John Cotter; Kevin Dowd
  20. Evaluating the Precision of Estimators of Quantile-Based Risk Measures By Kevin Dowd; John Cotter
  21. Extreme Measures of Agricultural Financial Risk By John Cotter; Kevin Dowd; Wyn Morgan

  1. 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 risk-aversion functions. To date there has been very little guidance on the choice of risk-aversion 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 'well-behaved' spectral risk measures.
    Date: 2011–03
  2. 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 GARCH-in-Mean (GARCH-M) model to estimate a time-varying 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. Out-of-sample 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 in-sample, risk aversion hedges for short hedgers outperform the OLS hedge ratio in a utility based comparison.
    Date: 2011–03
  3. 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 commonly-accepted 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 non-flexibility, 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
  4. 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
  5. 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 quasi-linearity;nonparamet- ric tests;revealed preferences.
    JEL: C14 D11 D12 D13
    Date: 2011
  6. By: Eike B. Kroll (Institute of Economic Theory and Statistics (ETS), Karlsruhe Institute of Technology); Judith N. Trarbach (Faculty of Economics and Management, Otto-von-Guericke University Magdeburg); Bodo Vogt (Faculty of Economics and Management, Otto-von-Guericke 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
  7. 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
  8. 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
  9. 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 risk-aversion. 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
  10. 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 cross-task 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
  11. By: Simone Cerreia-Vioglio; 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
  12. 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 state-dependent 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 price-supported 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
  13. By: Carolin E. Pflueger; Luis M. Viceira
    Abstract: This paper empirically analyzes the Expectations Hypothesis (EH) in inflation-indexed (or real) bonds and in nominal bonds in the US and in the UK. We strongly reject the EH in inflation-indexed 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 break-even 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
  14. By: Johannes Temme
    Abstract: Consider power utility maximization of terminal wealth in a 1-dimensional continuous-time 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 discrete-time strategies to the continuous-time counterpart. In addition, we provide and compare qualitative properties of the discrete-time and continuous-time optimizers.
    Date: 2011–03
  15. By: John Cotter; Kevin Dowd
    Abstract: This paper applies the Extreme-Value (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 risk-aversion 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
  16. By: Gabrielle Demange (PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - Ecole des Ponts ParisTech - Ecole Normale Supérieure de Paris - ENS Paris - INRA, EEP-PSE - 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 well-known results obtained when the underlying graph is a line. In contrast with other types of restrictions such as single-peakedness, 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
  17. 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 Sophia-Antipolis); Véronique Maume-Deschamps (SAF - Laboratoire de Sciences Actuarielle et Financière - Université Claude Bernard - Lyon I : EA2429); Clémentine Prieur (INRIA Rhône-Alpes / 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 MASCOT-NUM - CNRS : GDR3179)
    Abstract: This paper deals with the problem of estimating the level sets of an unknown distribution function $F$. A plug-in 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 ; Plug-in estimation ; Hausdorff distance ; Conditional Tail Expectation
    Date: 2011–03–28
  18. 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 self-commitment 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 hot-to-cold empathy gap, but not for the cold-to-hot empathy gap when subjects can self-commit to their initial choice.
    Keywords: Intrapersonal empathy gap, self-commitment, intrapersonal conflict, naiveté, sophistication
    JEL: C90
    Date: 2011–04–04
  19. 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 risk-aversion 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 time-varying market conditions. The goodness of fit of the model is confirmed by a variety of backtests.
    Date: 2011–03
  20. By: Kevin Dowd; John Cotter
    Abstract: This paper examines the precision of estimators of Quantile-Based 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
  21. 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 quantile-based 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

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