nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2011‒08‒29
nine papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Risky Curves: From Unobservable Utility to Observable Opportunity Sets By Daniel Friedman; Shyam Sunder
  2. Uncertainty Equivalents: Testing the Limits of the Independence Axiom By James Andreoni; Charles Sprenger
  3. Pricing risk and ambiguity: The effect of perspective taking By Stefan T. Trautmann; Ulrich Schmidt
  4. The Recovery Theorem By Stephen A. Ross
  5. Ambiguity in Individual Choice and Market Environments: On the Importance of Comparative Ignorance By Jonathan E. Alevy
  6. Rare Macroeconomic Disasters By Robert J. Barro; José F. Ursua
  7. Stochastic orderings with respect to a capacity and an application to a financial optimization problem By Miryana Grigorova
  8. Weighted Proportional Losses Solution By Jaume García Segarra; Miguel Ginés Vilar
  9. What is the Chance that the Equity Premium Varies over Time? Evidence from Predictive Regressions By Jessica A. Wachter; Missaka Warusawitharana

  1. By: Daniel Friedman (Dept. Economics, UC Santa Cruz; CESifo); Shyam Sunder (Yale School of Management)
    Abstract: Most theories of risky choice postulate that a decision maker maximizes the expectation of a Bernoulli (or utility or similar) function. We tour 60 years of empirical search and conclude that no such functions have yet been found that are useful for out-of-sample prediction. Nor do we find practical applications of Bernoulli functions in major risk-based industries such as finance, insurance and gambling. We sketch an alternative approach to modeling risky choice that focuses on potentially observable opportunities rather than on unobservable Bernoulli functions.
    Keywords: Expected utility, Risk aversion, St. Petersburg Paradox, Decisions under uncertainty, Option theory
    JEL: C91 C93 D11 D81 G11 G12 G22 L83
    Date: 2011–08
  2. By: James Andreoni; Charles Sprenger
    Abstract: There is convincing experimental evidence that Expected Utility fails, but when does it fail, how severely, and for what fraction of subjects? We explore these questions using a novel measure we call the uncertainty equivalent. We find Expected Utility performs well away from certainty, but fails near certainty for about 40% of subjects. Comparing non-Expected Utility theories, we strongly reject Prospect Theory probability weighting, we support disappointment aversion if amended to allow violations of stochastic dominance, but find the u-v model of a direct preference for certainty the most parsimonious approach.
    JEL: D81
    Date: 2011–08
  3. By: Stefan T. Trautmann; Ulrich Schmidt
    Abstract: There is a large literature showing that willingness-to-accept (WTA) is usually much higher than willingness-to-pay (WTP) in empirical studies although they should be roughly equal according to traditional economic theory. A second stream of literature shows that people are typically ambiguity averse, i.e. they prefer lotteries with known probabilities over lotteries with unknown ones. Our study combines both streams of literature and analyzes whether there is an interaction between the WTP-WTA disparity and ambiguity aversion
    Keywords: WTP-WTA disparity, ambiguity aversion, comparative ignorance
    JEL: C91 D81
    Date: 2011–08
  4. By: Stephen A. Ross
    Abstract: We can only estimate the distribution of stock returns but we observe the distribution of risk neutral state prices. Risk neutral state prices are the product of risk aversion – the pricing kernel – and the natural probability distribution. The Recovery Theorem enables us to separate these and to determine the market’s forecast of returns and the market’s risk aversion from state prices alone. Among other things, this allows us to determine the pricing kernel, the market risk premium, the probability of a catastrophe, and to construct model free tests of the efficient market hypothesis.
    JEL: E1 G0 G11 G12
    Date: 2011–08
  5. By: Jonathan E. Alevy (Department of Economics, University of Alaska Anchorage)
    Abstract: After Ellsberg’s thought experiments brought focus to the relevance of missing information for choice, extensive efforts have been made to understand ambiguity theoretically and empirically (Ellsberg 1961). Fox and Tversky (1995) make an important contribution to understanding behavioral responses to ambiguity. In an individual choice setting they demonstrate that an aversion to ambiguous lotteries arises only when a comparison to unambiguous lotteries is available. The current study advances this literature by exploring the importance of Fox and Tversky’s finding for market outcomes and finds support for their Comparative Ignorance Hypothesis in the market setting.
    Keywords: ambiguity, asset market experiment, comparitive ignorance
    JEL: C91 C92 D81 G12
    Date: 2011
  6. By: Robert J. Barro; José F. Ursua
    Abstract: The potential for rare macroeconomic disasters may explain an array of asset-pricing puzzles. Our empirical studies of these extreme events rely on long-term data now covering 28 countries for consumption and 40 for GDP. A baseline model calibrated with observed peak-to-trough disaster sizes accords with the average equity premium with a reasonable coefficient of relative risk aversion. High stock-price volatility can be explained by incorporating time-varying long-run growth rates and disaster probabilities. Business-cycle models with shocks to disaster probability have implications for the cyclical behavior of asset returns and corporate leverage, and international versions may explain the uncovered-interest-parity puzzle. Richer models of disaster dynamics allow for transitions between normalcy and disaster, bring in post-crisis recoveries, and use the full time series on consumption. Potential future research includes applications to long-term economic growth and environmental economics and the use of stock-price options and other variables to gauge time-varying disaster probabilities.
    JEL: E01 E44 G12 G15
    Date: 2011–08
  7. By: Miryana Grigorova (LPMA - Laboratoire de Probabilités et Modèles Aléatoires - CNRS : UMR7599 - Université Pierre et Marie Curie - Paris VI - Université Paris Diderot - Paris 7)
    Abstract: In an analogous way to the classical case of a probability measure, we extend the notion of an increasing convex (concave) stochastic dominance relation to the case of a normalised monotone (but not necessarily additive) set function also called a capacity. We give different characterizations of this relation establishing a link to the notions of distribution function and quantile function with respect to the given capacity. The Choquet integral is extensively used as a tool. We state a new version of the classical upper (resp. lower) Hardy-Littlewood's inequality generalized to the case of a continuous from below concave (resp. convex) capacity. We apply our results to a financial optimization problem whose constraints are expressed by means of the increasing convex stochastic dominance relation with respect to a capacity.
    Keywords: stochastic orderings; increasing convex stochastic dominance; Choquet integral; quantile function with respect to a capacity; stop-loss ordering; Choquet expected utility; distorted capacity; generalized Hardy-Littlewood's inequalities; distortion risk measure; ambiguity
    Date: 2011–08–15
  8. By: Jaume García Segarra (Fundamentos del Análisis Económico (Economics Department), Universitat Jaume I); Miguel Ginés Vilar (Fundamentos del Análisis Económico (Economics Department), Universitat Jaume I)
    Abstract: We propose and characterize a new solution for problems with asymmetric bargaining power among the agents that we named weighted proportional losses solution. It is specially interesting when agents are bargaining under restricted probabilistic uncertainty. The weighted proportional losses assigns to each agent losses proportional to her ideal utility and also proportional to her bargaining power. This solution is always individually rational, even for 3 or more agents and it can be seen as the normalized weighted equal losses solution. When bargaining power among the agents is equal, the weighted proportional losses solution becomes the Kalai-Smorodinsky solution. We characterize our solution in the basis of restricted monotonicity and restricted concavity. A consequence of this result is an alternative characterization of Kalai-Smorodinsky solution which includes contexts with some kind of uncertainty. Finally we show that weighted proportional losses solution satisfyies desirable properties as are strong Pareto optimality for 2 agents and continuity also fulfilled by Kalai-Smorodinsky solution, that are not satisfied either by weighted or asymmetric Kalai-Smorodinsky solutions.
    Date: 2011–08–01
  9. By: Jessica A. Wachter; Missaka Warusawitharana
    Abstract: We examine the evidence on excess stock return predictability in a Bayesian setting in which the investor faces uncertainty about both the existence and strength of predictability. Departing from previous studies, we do not assume that the regressor is strictly exogenous. When we apply our methods to the dividend-price ratio, we find that even investors who are quite skeptical about the existence of predictability sharply modify their views in favor of predictability when confronted by the historical time series of returns and predictor variables. We find that taking into account the stochastic properties of the regressor has a substantial impact on the investor's inference about returns.
    JEL: C11 C22 G11
    Date: 2011–08

This nep-upt issue is ©2011 by Alexander Harin. It is provided as is without any express or implied warranty. It may be freely redistributed in whole or in part for any purpose. If distributed in part, please include this notice.
General information on the NEP project can be found at For comments please write to the director of NEP, Marco Novarese at <>. Put “NEP” in the subject, otherwise your mail may be rejected.
NEP’s infrastructure is sponsored by the School of Economics and Finance of Massey University in New Zealand.