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on Utility Models and Prospect Theory |
| By: | Simon Grant (Dept. of Economics, Rice University and School of Economics, University of Queensland); Ben Polak (Cowles Foundation, Yale University) |
| Abstract: | We axiomatize, in an Anscombe-Aumann framework, the class of preferences that admit a representation of the form V(f) = mu - rho(d), where mu is the mean utility of the act f with respect to a given probability, d is the vector of state-by-state utility deviations from the mean, and rho(d) is a measure of (aversion to) dispersion that corresponds to an uncertainty premium. The key feature of these mean-dispersion preferences is that they exhibit constant absolute uncertainty aversion. This class includes many well-known models of preferences from the literature on ambiguity. We show what properties of the dispersion function rho(dot) correspond to known models, to probabilistic sophistication, and to some new notions of uncertainty aversion. |
| Keywords: | Ambiguity aversion, Translation invariance, Dispersion, Uncertainty, Probabilistic sophistication |
| JEL: | D81 |
| Date: | 2011–06 |
| URL: | http://d.repec.org/n?u=RePEc:cwl:cwldpp:1805&r=upt |
| By: | Santiago Moreno-Bromberg; Traian Pirvu; Anthony R\'eveillac |
| Abstract: | This paper studies the problem of optimal investment with CRRA (constant, relative risk aversion) preferences, subject to dynamic risk constraints on trading strategies. The market model considered is continuous in time and incomplete; furthermore, financial assets are modeled by It\^{o} processes. The dynamic risk constraints (time, state dependent) are generated by risk measures. The optimal trading strategy is characterized by a quadratic BSDE. Special risk measures (\textit{Value-at-Risk}, \textit{Tail Value-at-Risk} and \textit{Limited Expected Loss}) are considered and a three--fund separation result is established in these cases. Numerical results emphasize the effect of imposing risk constraints on trading. |
| Date: | 2011–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1106.1702&r=upt |
| By: | Helga Habis (Institute of Economics - Hungarian Academy of Sciences); P. Jean-Jacques Herings (Department of Economics, Universiteit Maastricht) |
| Abstract: | We introduce the concept of a TUU-game, a transferable utility game with uncertainty. In a TUU-game there is uncertainty regarding the payoffs of coalitions. One out of a finite number of states of nature materializes and conditional on the state, the players are involved in a particular transferable utility game. We consider the case without ex ante commitment possibilities and propose the Weak Sequential Core as a solution concept. We characterize the Weak Sequential Core and show that it is non-empty if all ex post TUgames are convex. |
| Keywords: | transferable utility games, uncertainty, Weak Sequential Core |
| JEL: | C71 C73 |
| Date: | 2011–05 |
| URL: | http://d.repec.org/n?u=RePEc:has:discpr:1120&r=upt |
| By: | Jochen Zahn |
| Abstract: | We discuss utility based pricing and hedging of jump diffusion processes with emphasis on the practical applicability of the framework. We point out two difficulties that seem to limit this applicability, namely drift dependence and essential risk aversion independence. We suggest to solve these by a re-interpretation of the framework. This leads to the notion of an implied drift. We also present a heuristic derivation of the marginal indifference price and the marginal optimal hedge that might be useful in numerical computations. |
| Date: | 2011–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1106.1395&r=upt |
| By: | Charles Engel |
| 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. |
| JEL: | F30 F31 G12 |
| Date: | 2011–06 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:17116&r=upt |