nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2011‒04‒16
four papers chosen by
Alexander Harin
Modern University for the Humanities

  1. First-order (Conditional) Risk Aversion, Background Risk and Risk Diversification By Georges Dionne; Jingyuan Li
  2. The Role of Intuition and Reasoning in Driving Aversion to Risk and Ambiguity By Jeffrey V. Butler; Luigi Guiso; Tullio Jappelli
  3. Utility Maximization, Risk Aversion, and Stochastic Dominance By Mathias Beiglboeck; Johannes Muhle-Karbe; Johannes Temme
  4. The Real Exchange Rate, Real Interest Rates, and the Risk Premium By Engel, Charles

  1. By: Georges Dionne; Jingyuan Li
    Abstract: In the literature, utility functions in the expected utility class are generically limited to second-order (conditional) risk aversion, while non-expected utility functions can exhibit either first-order or second-order (conditional) risk aversion. This paper extends the concepts of order of conditional risk aversion to orders of conditional dependent risk aversion. We show that first-order conditional dependent risk aversion is consistent with the framework of the expected utility hypothesis. We relate our results to risk diversification and provide additional insights into its application in different economic and finance examples.
    Keywords: Expected utility theory, first-order conditional dependent risk aversion, background risk, risk diversification
    JEL: D81
    Date: 2011
  2. By: Jeffrey V. Butler (Einaudi Institute for Economics and Finance (EIEF)); Luigi Guiso (European University Institute and EIEF); Tullio Jappelli (University of Naples Federico II, CSEF and CEPR)
    Abstract: Using information on a large sample of retail investors and experimental data we find that risk aversion and risk ambiguity are correlated: individuals who dislike risk also dislike ambiguity. We show that what links these traits is the way people handle decisions. Intuitive thinkers are less averse to risk and less averse to ambiguity than individuals who base their decisions on effortful reasoning. We confirm this finding in a series of experiments. One interpretation of our results is that the high-speed of intuitive thinking puts intuitive thinkers at a comparative advantage in situations involving high risk and ambiguity, making them less averse to both. Consistent with this view we show evidence from the field and from the lab that intuitive thinkers perform better than deliberative thinkers when making decisions in highly ambiguous and risky environments. We also find that attitudes toward risk and ambiguity are related to different individual characteristics and wealth. While the wealthy are less averse to risk, they dislike ambiguity more, a finding that has implications for financial puzzles.
    Keywords: Risk Aversion, Risk Ambiguity, Decision Theory, Dual Systems, Intuitive Thinking
    JEL: D81 D83
    Date: 2011–04–05
  3. By: Mathias Beiglboeck; Johannes Muhle-Karbe; Johannes Temme
    Abstract: Consider an investor trading dynamically to maximize expected utility from terminal wealth. Our aim is to study the dependence between her risk aversion and the distribution of the optimal terminal payoff. Economic intuition suggests that high risk aversion leads to a rather concentrated distribution, whereas lower risk aversion results in a higher average payoff at the expense of a more widespread distribution. Dybvig and Wang [J. Econ. Theory, 2011, to appear] find that this idea can indeed be turned into a rigorous mathematical statement in one-period models. More specifically, they show that lower risk aversion leads to a payoff which is larger in terms of second order stochastic dominance. In the present study, we extend their results to (weakly) complete continuous-time models. We also complement an ad-hoc counterexample of Dybvig and Wang, by showing that these results are "fragile", in the sense that they fail in essentially any model, if the latter is perturbed on a set of arbitrarily small probability. On the other hand, we establish that they hold for power investors in models with (conditionally) independent increments.
    Date: 2011–04
  4. By: Engel, Charles (Department of Economics, University of Wisconsin, Madison, USA)
    Abstract: The well-known uncovered interest parity puzzle arises from the empirical regularity that, among developed country pairs, the high interest rate country tends to have high expected returns on its short term assets. At the same time, another strand of the literature has documented that high real interest rate countries tend to have currencies that are strong in real terms – indeed, stronger than can be accounted for by the path of expected real interest differentials under uncovered interest parity. These two strands – one concerning short-run expected changes and the other concerning the level of the real exchange rate – have apparently contradictory implications for the relationship of the foreign exchange risk premium and interest-rate differentials. This paper documents the puzzle, and shows that existing models appear unable to account for both empirical findings. The features of a model that might reconcile the findings are discussed.
    Keywords: Uncovered interest parity, foreign exchange risk premium, forward premium puzzle
    JEL: F30 F31 F41 G12
    Date: 2011–04

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