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on Utility Models and Prospect Theory |
| By: | Kaito Sato |
| Abstract: | Raiffa (1961) criticizes ambiguity-averse preferences by claiming that hedging is possible with randomization of choices. We argue that the timing of randomization is crucial for hedging. Ex-ante randomizations, which are randomizations before a state is realized, could provide only ex-ante hedging but not ex-post hedging, in contrast to ex-post randomizations, which are randomizations after a state is realized. However, these two randomizations have been assumed to be indifferent under the reversal of order axiom proposed by Anscombe and Aumann (1963). We, therefore, propose a weaker axiom, the indifference axiom, which allows heterogeneous attitudes toward the timing of randomization. By using this new axiom as well as standard axioms, we provide an extension of Gilboa and Schmeidler’s (1989) Maxmin preferences that treats a preference for ex-ante randomizations separately from a preference for ex-post randomizations. In the representation, a single parameter characterizes a preference for ex-ante randomizations. By parsimoniously changing only the value of that single parameter, the representation can be consistent with Raiffa’s (1961) normative argument as well as recent experimental evidence. |
| JEL: | D81 |
| Date: | 2011–04–10 |
| URL: | http://d.repec.org/n?u=RePEc:nwu:cmsems:1524&r=upt |
| By: | Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Panthéon-Sorbonne - Paris I); Wayne Tarrant (Wingate University - Department of Mathematics) |
| Abstract: | Regulation and Risk management in banks depend on underlying risk measures. In general this is the only purpose that is seen for risk measures. In this paper, we suggest that the reporting of risk measures can be used to determine the loss distribution function for a financial entity. We demonstrate that a lack of sufficient information can lead to ambiguous risk situations. We give examples, showing the need for the reporting of multiple risk measures in order to determine a bank's loss distribution. We conclude by suggesting a regulatory requirement of multiple risk measures being reported by banks, giving specific recommendations. |
| Keywords: | Risk measure, Value at Risk, bank capital, Basel II accord. |
| Date: | 2011–08 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00639489&r=upt |
| By: | Francesco Passarelli |
| Abstract: | This paper describes policy alternatives as lotteries, and studies how policy preferences are distorted by the cognitive anomalies postulated by Prospect Theory. Loss aversion induces a status quo bias. However, due to the reflection effect, the bias is asymmetric: too moderate attitudes toward a good reform or a good candidate, and too low severity toward bad politics. The reflection effect also determines low loyalty in partisan voting and weak concerns about partisan issues. Preferences about nonpartisan issues are independent of wealth because people use the status quo as a reference point. Ambitious platforms have more chances to pass than incremental and detailed changes because people are risk seeking in the realm of losses. In general, according to Prospect Theory the policy conflict within the society is smoother than under full rationality. Moreover, a pure majority system yields either prolonged conservatism or a radical abandonment of the status quo. |
| Keywords: | prospect theory, behavioral economics, voting behavior, behavioral political economy |
| JEL: | C9 D72 D81 H1 |
| Date: | 2011–11 |
| URL: | http://d.repec.org/n?u=RePEc:slp:islawp:islawp39&r=upt |
| By: | Richard M. H. Suen (University of Connecticut) |
| Abstract: | This paper examines the theoretical foundations of precautionary wealth accumulation in a multi-period model where consumers face uninsurable earnings risk and borrowing constraints. We begin by characterizing the consumption function of individual consumers. We show that consumption function is concave when the utility function has strictly positive third derivative and the inverse of absolute prudence is a concave function. These conditions encompass all HARA utility functions with strictly positive third derivative as special cases. We then show that when consumption function is concave, a mean-preserving spread in earnings risk would encourage wealth accumulation at both the individual and aggregate levels. |
| Keywords: | Consumption function, borrowing constraints, precautionary saving |
| JEL: | D81 D91 E21 |
| Date: | 2011–11 |
| URL: | http://d.repec.org/n?u=RePEc:uct:uconnp:2011-23&r=upt |
| By: | Vicky Henderson; Gechun Liang |
| Abstract: | This paper considers exponential utility indifference pricing for a multidimensional non-traded assets model and provides two approximations for the utility indifference price: a linear approximation by Picard iteration and a semigroup approximation by splitting techniques. The key tool is the probabilistic representation for the utility indifference price by the solution of fully coupled linear forward-backward stochastic differential equations. We apply our methodology to study the counterparty risk of derivatives in incomplete markets. |
| Date: | 2011–11 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1111.3856&r=upt |
| By: | Tim Bollerslev; James Marrone; Lai Xu; Hao Zhou |
| Abstract: | Recent empirical evidence suggests that the variance risk premium, or the difference between risk-neutral and statistical expectations of the future return variation, predicts aggregate stock market returns, with the predictability especially strong at the 2-4 month horizons. We provide extensive Monte Carlo simulation evidence that statistical finite sample biases in the overlapping return regressions underlying these findings can not ``explain" this apparent predictability. Further corroborating the existing empirical evidence, we show that the patterns in the predictability across different return horizons estimated from country specific regressions for France, Germany, Japan, Switzerland and the U.K. are remarkably similar to the pattern previously documented for the U.S. Defining a ``global" variance risk premium, we uncover even stronger predictability and almost identical cross-country patterns through the use of panel regressions that effectively restrict the compensation for world-wide variance risk to be the same across countries. Our findings are broadly consistent with the implications from a stylized two-country general equilibrium model explicitly incorporating the effects of world-wide time-varying economic uncertainty. |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedgfe:2011-52&r=upt |