
on Utility Models and Prospect Theory 
By:  Massimo Guidolin; Francesca Rinaldi 
Abstract:  Empirical research suggests that investors’ behavior is not well described by the traditional paradigm of (subjective) expected utility maximization under rational expectations. A literature has arisen that models agents whose choices are consistent with models that are less restrictive than the standard subjective expected utility framework. In this paper we survey the literature that has explored the implications of decisionmaking under ambiguity for financial market outcomes, such as portfolio choice and equilibrium asset prices. We conclude that the ambiguity literature has led to a number of significant advances in our ability to rationalize empirical features of asset returns and portfolio decisions, such as the failure of the twofund separation theorem in portfolio decisions, the modest exposure to risky securities observed for a majority of investors, the home equity preference in international portfolio diversification, the excess volatility of asset returns, the equity premium and the riskfree r ate puzzles, and the occurrence of trading breakdowns. JEL codes: G10, G18, D81. Keywords: ambiguity, ambiguityaversion, participation, liquidity, asset pricing.By Massimo Guidolin, Francesca Rinaldi 
Date:  2011 
URL:  http://d.repec.org/n?u=RePEc:igi:igierp:417&r=upt 
By:  Giocoli, Nicola 
Abstract:  Bayesian rationality is the paradigm of rational behavior in neoclassical economics. A rational agent in an economic model is one who maximizes her subjective expected utility and consistently revises her beliefs according to Bayes’s rule. The paper raises the question of how, when and why this characterization of rationality came to be endorsed by mainstream economists. Though no definitive answer is provided, it is argued that the question is far from trivial and of great historiographic importance. The story begins with Abraham Wald’s behaviorist approach to statistics and culminates with Leonard J. Savage’s elaboration of subjective expected utility theory in his 1954 classic The Foundations of Statistics. It is the latter’s acknowledged fiasco to achieve its planned goal, the reinterpretation of traditional inferential techniques along subjectivist and behaviorist lines, which raises the puzzle of how a failed project in statistics could turn into such a tremendous hit in economics. A couple of tentative answers are also offered, involving the role of the consistency requirement in neoclassical analysis and the impact of the postwar transformation of US business schools. 
Keywords:  Savage; Wald; rational behavior; Bayesian decision theory; subjective probability; minimax rule; statistical decision functions; neoclassical economics 
JEL:  B31 B21 D81 
Date:  2011–10–14 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:34117&r=upt 
By:  Wang, Gaowang 
Abstract:  This paper reexamines the relationship between the time preference rate and the real interest rate in the neoclassical growth model by introducing Keynesian time preference. It is shown that the longrun behavior of the neoclassical growth model persists. When introduucing money by moneyinutility, money is superneutral and the optimal monetary policy is the Friedman rule. 
Keywords:  Keynesian time preference; Monetary Superneutrality; Optimum Quantity of Money 
JEL:  O42 E31 E5 
Date:  2011–01–01 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:34063&r=upt 
By:  Chiu Yu Ko (Boston College) 
Abstract:  This paper extends Bernheim and Whinston's (1986) menu auction model under transferable utilities to a framework with nontransferable utilities and budget constraints. Under appropriate definitions of equilibria, it is shown that every truthful Nash equilibrium (TNE) is a coalitionproof Nash equilibrium (CPNE) and that the set of TNE payoffs and the set of CPNE payoffs are equivalent, as in a transferable utility framework. The existence of a CPNE is assured in contrast with the possible nonexistence of Nash equilibrium under the definition by Dixit, Grossman, and Helpman (1997). Moreover, the set of CPNE payoffs is equivalent to the bidderoptimal weak core. 
Keywords:  nontransferable utility, menu auction, coalitionproof Nash equilibrium, truthful Nash equilibrium 
JEL:  C72 D79 
Date:  2011–10–20 
URL:  http://d.repec.org/n?u=RePEc:boc:bocoec:787&r=upt 
By:  Vilsmeier, Johannes 
Abstract:  In this paper we ‘update’ the option implied probability of default (option iPoD) approach recently suggested in the literature. First, a numerically more stable objective function for the estimation of the risk neutral density is derived whose integrals can be solved analytically. Second, it is reasoned that the originally proposed approach for the estimation of the PoD has some serious drawbacks and hence an alternative procedure is suggested that is based on the Lagrange multipliers. Carrying out numerical evaluations and a practical application we find that the framework provides very promising results. 
Keywords:  Option Implied Probability of Default; Risk Neutral Density; Cross Entropy 
Date:  2011–10–12 
URL:  http://d.repec.org/n?u=RePEc:bay:rdwiwi:22326&r=upt 
By:  Elias Albagli (USC Marshall); Christian Hellwig (Toulouse School of Economics); Aleh Tsyvinski (Dept. of Economics, Yale University) 
Abstract:  We propose a theory of asset prices that emphasizes heterogeneous information as the main element determining prices of different securities. Our main analytical innovation is in formulating a model of noisy information aggregation through asset prices, which is parsimonious and tractable, yet flexible in the specification of cash flow risks. We show that the noisy aggregation of heterogeneous investor beliefs drives a systematic wedge between the impact of fundamentals on an asset price, and the corresponding impact on cash flow expectations. The key intuition behind the wedge is that the identity of the marginal trader has to shift for different realization of the underlying shocks to satisfy the marketclearing condition. This identity shift amplifies the impact of price on the marginal trader's expectations. We derive tight characterization for both the conditional and the unconditional expected wedges. Our first main theorem shows how the sign of the expected wedge (that is, the difference between the expected price and the dividends) depends on the shape of the dividend payoff function and on the degree of informational frictions. Our second main theorem provides conditions under which the variability of prices exceeds the variability for realized dividends. We conclude with two applications of our theory. First, we highlight how heterogeneous information can lead to systematic departures from the ModiglianiMiller theorem. Second, in a dynamic extension of our model we provide conditions under which bubbles arise. 
Keywords:  Information aggregation, Information wedge, Heterogeneous beliefs, ModiglianiMiller theorem, Bubbles 
JEL:  G12 G14 G30 E44 
Date:  2011–10 
URL:  http://d.repec.org/n?u=RePEc:cwl:cwldpp:1827&r=upt 
By:  Bosi, Gianni; Zuanon, Magalì 
Abstract:  We characterize weak continuity of an interval order on a topological space by using the concept of a scale in a topological space. 
Keywords:  Weakly continuous interval order; continuous numerical representation 
JEL:  D00 C60 
Date:  2011–10–17 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:34182&r=upt 
By:  Maria Laura Pesce (Università di Napoli Federico II and CSEF) 
Abstract:  In most economies, a fair allocation does not exist. Thus, it seems that we are condemned to live in an unfair world, since we are not happy with what we have and we look at the others with envious eyes. In this paper we want to give an hope for a more equitable society. 
Keywords:  Asymmetric information; fair allocation; constrained market equilibrium; Maximin and Bayesian expected utility function. 
JEL:  D63 D82 
Date:  2011–10–10 
URL:  http://d.repec.org/n?u=RePEc:sef:csefwp:292&r=upt 
By:  Paolo Crosetto (Max Planck Institute for Economics, Jena); Alexia Gaudeul (Graduate School "Human Behavior in Social and Economic Change" (GSBC), Friedrich Schiller University, Jena) 
Abstract:  Consumers make mistakes when facing complex purchasing decision problems but if at least some consumers choose only among offers that are easy to compare with others then firms will adopt common ways to present their offers and thus make choice easier (Gaudeul and Sugden, 2011). We design an original experiment to identify consumers' choice heuristics in the lab. Subjects are presented with menus of offers and do appear to favour offers that are easy to compare with others in the menu. While not all subjects do so, this is enough to deter firms from introducing spurious complexity in the way they present products. 
Keywords:  Bounded Rationality, Cognitive Limitations, Common Standards, Consumer Choice, Experimental Economics, Heuristics, Libertarian Paternalism, Pricing Formats, Spurious Complexity 
JEL:  D83 L13 D18 
Date:  2011–10–12 
URL:  http://d.repec.org/n?u=RePEc:jrp:jrpwrp:2011044&r=upt 
By:  Pástor, Luboš; Veronesi, Pietro 
Abstract:  We study the pricing of political uncertainty in a general equilibrium model of government policy choice. We find that political uncertainty commands a risk premium whose magnitude is larger in poorer economic conditions. Political uncertainty reduces the value of the implicit put protection that the government provides to the market. It also makes stocks more volatile and more correlated when the economy is weak. In addition, we find that government policies cannot be judged by the stock market response to their announcement. Announcements of deeper reforms tend to elicit less favorable stock market reactions. 
Keywords:  Bayesian; government; learning; political; put; risk premium; uncertainty 
JEL:  G12 G18 
Date:  2011–10 
URL:  http://d.repec.org/n?u=RePEc:cpr:ceprdp:8601&r=upt 