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on Utility Models and Prospect Theory |
| By: | Traeger, Christian P. |
| Abstract: | The paper incorporates qualitative differences of probabilistic beliefs into a rational (or normatively motivated) decision framework. Probabilistic beliefs can range from objective probabilities to pure guesstimates. The decision maker in the present model takes into account his confidence in beliefs when evaluating general uncertain situations. From an axiomatic point of view, the approach stays as close as possible to the widespread von Neumann-Morgenstern framework. The resulting representation uses only basic tools from risk analysis, but employs them recursively. The paper extends the concept of smooth ambiguity aversion to a more general notion of aversion to the subjectivity of belief. As a special case, the framework permits a threefold disentanglement of intertemporal substitutability, Arrow-Pratt risk aversion, and smooth ambiguity aversion. A decision maker’s preferences can nest a variety of widespread decision criteria, which are selected according to his confidence in the uncertainty assessment of a particular setting. |
| Keywords: | ambiguity, confidence, subjective beliefs, expected utility, intertemporal substitutability, intertemporal risk aversion, recursive utility, uncertainty, climate change, behavior, Agricultural and Resource Economics |
| Date: | 2011–05–01 |
| URL: | http://d.repec.org/n?u=RePEc:cdl:agrebk:qt0gw7t7vn&r=upt |
| By: | Stanislav Khrapov (New Economic School) |
| Abstract: | Hansen (2011) considers risks associated with cash flows at alternative horizons. He shows that in the long run many investor preference specifications do not imply risk premia substantially different from those implied by simple expected utility model. The main result of this paper is that the generalized disappointment aversion model of Routledge & Zin (2010) amplifies risk premium not only in the short run but also for assets that pay off long into the future. The reason behind this result is that this utility alters the risk-neutral distribution of future economy outcomes relative to the expected utility. The latter shares the risk-neutral distribution with more general Epstein & Zin (1989) recursive utility. I also analyze the risk premium term structure implied by the three utilities and find that its slope critically depends on the volatility of the transient payoff component with high enough volatility leading to negatively sloped term structure. |
| Keywords: | term structure of risk premium; Epstein-Zin utility; generalized disappointment aversion; finite state economy; Markov chain |
| JEL: | G12 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:cfr:cefirw:w0169&r=upt |
| By: | D Peel; Ivan Paya; T M Niguez; J Perote |
| Abstract: | Economic growth models under uncertainty and rational agents with CRRA utility have been shown to provide quite fragile explanations of consumers.choice as equlib- rium comsumption paths (expected utility) are drastically dependant on distributional assumptions. We show that assuming a SNP distribution for random consumption provides stability to general equilibrium models as expected utility exists for any value of the marginal rate of substitution over time. |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:lan:wpaper:2350&r=upt |
| By: | Traeger, Christian P. |
| Abstract: | The paper analyzes the discount rate under uncertainty. The analysis complements the probabilistic characterization of uncertainty by a measure of confidence. Special cases of the model comprise discounting under smooth ambiguity aversion as well as discounting under a disentanglement of risk aversion from aversion to intertemporal substitution. The paper characterizes the general class of preferences for which uncertainty implies a reduction of the discount rate. It also characterizes how the more comprehensive description of uncertainty changes the discount rate with respect to the standard model. The paper relates different results in the literature by switching between different risk measures. It presents a parametric extension of the Ramsey discounting formula that takes into account confidence into future growth estimates and a measure of aversion to the lack of confidence. If confidence decreases in the futurity of the growth forecast, the discount rates have a falling term structure even in the case of an iid growth process. |
| Keywords: | uncertainty, discounting, climate change, ambiguity, confidence, subjective beliefs, prudence, pessimism, expected utility, intertemporal substitutability, intertemporal risk aversion, Agricultural and Resource Economics |
| Date: | 2011–09–01 |
| URL: | http://d.repec.org/n?u=RePEc:cdl:agrebk:qt61m836d1&r=upt |
| By: | Georges Dionne; Jingyuan Li; Cedric Okou |
| Abstract: | We extend the Consumption-based CAPM (C-CAPM) model to representative agents with different risk attitudes. We first use the concept of expectation dependence and show that for a risk averse representative agent, it is the first-degree expectation dependence (FED) rather than the covariance that determines C-CAPM’s riskiness. We extend the assumption of risk aversion to prudence and propose the measure of second-degree expectation dependence (SED) to obtain the values of asset price and equity premium. These theoretical results are linked to the equity premium puzzle. Using the same dataset as in Campbell (2003), the estimated measures of relative risk aversion from FED and SED approximations are much lower than those obtained in the original study and correspond to the theoretical values often discussed in the literature. The theoretical model is then generalized to higher-degree risk changes and higher-order risk averse representative agents. |
| Keywords: | Consumption-based CAPM, Risk premium, Equity premium puzzle, Expectations dependence, Ross risk aversion |
| JEL: | D51 D80 G12 |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:lvl:lacicr:1214&r=upt |
| By: | Glenn W. Harrison; Jimmy MartÃnez-Correa; J. Todd Swarthout |
| Abstract: | The reduction of compound lotteries (ROCL) has assumed a central role in the evaluation of behavior towards risk and uncertainty. We present experimental evidence on its validity in the domain of objective probabilities. Our experiment explicitly recognizes the impact that the random lottery incentive mechanism payment procedure may have on preferences, and so we collect data using both "1-in-1" and "1-in-K" payment procedures, where K>1. We do not find violations of ROCL when subjects are presented with only one choice that is played for money. However, when individuals are presented with many choices and random lottery incentive mechanism is used to select one choice for payoff, we do find violations of ROCL. These results are supported by both non-parametric analysis of choice patterns, as well as structural estimation of latent preferences. We find evidence that the model that best describes behavior when subjects make only one choice is the Rank-Dependent Utility model. When subjects face many choices, their behavior is better characterized by our source-dependent version of the Rank-Dependent Utility model which can account for violations of ROCL. We conclude that payment protocols can create distortions in experimental tests of basic axioms of decision theory. |
| Date: | 2012–03 |
| URL: | http://d.repec.org/n?u=RePEc:exc:wpaper:2012-04&r=upt |
| By: | Marielle Brunette (Laboratoire d'Economie Forestière, INRA - AgroParisTech) |
| Keywords: | risk, communication, rational choice, insentivity to scope, gain/loss asymmetry. |
| JEL: | C91 D01 D81 |
| Date: | 2012–01 |
| URL: | http://d.repec.org/n?u=RePEc:lef:wpaper:2012-01&r=upt |
| By: | Koedijk, Kees; Pownall, Rachel A J; Statman, Meir |
| Abstract: | Financial well-being is distinct from income. Some people with high incomes suffer low financial well-being, as their incomes fall short of their aspirations. Such people feel propelled to reach their aspirations by taking risk and willing to bear losses. Conversely, some people with low incomes enjoy high financial well-being, as their incomes exceed their aspirations. We find that people whose aspirations exceed their income are less risk-averse and less loss-averse than people whose incomes exceed their aspirations. We also find that competitive and status-seeking people are less risk-averse than people who are less competitive and status-seeking, and that status-seeking people are less loss-averse than people who are not as status-seeking. |
| Keywords: | behavioural portfolio theory; loss-aversion; prospect theory; risk-taking; subjective well-being |
| JEL: | D81 G11 |
| Date: | 2012–03 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:8904&r=upt |
| By: | Traeger, Christian P. |
| Abstract: | Uncertainty has an almost negligible impact on project value in the economicstandard model. I show that a comprehensive evaluation of uncertainty and uncertainty attitude changes this picture fundamentally. The analysis relies on the discount rate, which is the crucial determinant in balancing immediate costs against future benefits and the single most important determinant of optimal mitigation policies in the integrated assessment of climate change. The paper examines two shortcomings in the recent debate and the current models addressing climate change assessment. First, removing an implicit assumption of (intertemporal) risk neutrality reduces the growth effect in social discounting and significantly amplifies the importance of risk and correlation. Second, debate and models largely overlook the difference in attitude with respect to risk and with respect to non-risk uncertainty. The paper derives the resulting changes of the risk-free and the stochastic social discount rate and points out the importance of even thin tailed uncertainty for climate change evaluation. It discusses combinations ofuncertainty and correlation that reduce the social discount rate to pure preference. In a theoretical contribution, the paper extends the smooth ambiguity model by providing a threefold disentanglement between, risk aversion, ambiguity aversion, and the propensityto smooth consumption over time. |
| Keywords: | ambiguity, climate change, cost benefit analysis, discounting, intertemporal substitutability, risk aversion, uncertainty, Agricultural and Resource Economics, Natural Resources and Conservation |
| Date: | 2012–01–26 |
| URL: | http://d.repec.org/n?u=RePEc:cdl:agrebk:qt2w614303&r=upt |
| By: | Crost, Benjamin; Traeger, Christian P. |
| Abstract: | We analyze the impact of damage uncertainty on optimal mitigation policies in the integrated assessment of climate change. Usually, these models analyzeuncertainty by averaging deterministic paths. In contrast, we build a consistentmodel deriving optimal policy rules under persistent uncertainty. For this purpose,we construct a close relative of the DICE model in a recursive dynamic programming framework. Our recursive approach allows us to disentangle effects of risk, risk aversion, and aversion to intertemporal substitution. We analyze different ways how damage uncertainty can affect the DICE equations. We compare the optimal policies to those resulting from the wide-spread ex-ante uncertainty approach averaging deterministic paths. |
| Keywords: | climate change, uncertainty, integrated assessment, risk aversion, intertemporal substitution, recursive utility, dynamic programming, Agricultural and Resource Economics, Agriculture, Agriculture Operations, and Related Sciences, Natural Resources and Conservation |
| Date: | 2011–11–01 |
| URL: | http://d.repec.org/n?u=RePEc:cdl:agrebk:qt1562s275&r=upt |
| By: | Garance Genicot, Orazio Attanasio, Abigail Barr, Juan Camilo Cardenas and Costas Meghir (Department of Economics, Georgetown University) |
| Abstract: | Using data from an experiment conducted in 70 Colombian communities, we investigate who pools risk with whom when trust is crucial to enforce risk pooling arrangements. We explore the roles played by risk attitudes and social networks. Both theoretically and empirically, we nd that close friends and relatives group assortatively on risk attitudes and are more likely to join the same risk pooling group, while unfamiliar participants group less and rarely assort. These ndings indicate that where there are advantages to grouping assortatively on risk attitudes those advantages may be inaccessible when trust is absent or low. |
| Keywords: | Field experiment; risk sharing; social sanctions; insurance; group formation; matching. |
| Date: | 2011–01–05 |
| URL: | http://d.repec.org/n?u=RePEc:geo:guwopa:gueconwpa~11-11-05&r=upt |
| By: | Gong, Liutang; Zou, Heng-fu |
| Abstract: | In this paper, we study risk-taking, fiscal policies, and asset pricing in a stochastic model of growth with non-expected utility function and the spirit of capitalism. With specific assumptions on the production technology, preferences, and stochastic shocks, we derive the explicit solutions to the growth rates of consumption and savings and equilibrium returns on all assets. Finally, we give the effects of fiscal policies, the spirit of capitalism, and stochastic shocks on growth, asset pricing, and welfare. |
| Keywords: | the spirit of capitalism; fiscal policies; asset pricing; stochastic growth; non-expected utility |
| JEL: | G1 E0 H0 |
| Date: | 2012–01–01 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:37426&r=upt |
| By: | Seidl, Christian |
| Abstract: | The Petersburg Paradox and its solutions are formulated in a uniform arrangement centered around d'Alembert's ratio test. All its aspects are captured using three mappings, a mapping from the natural numbers to the space of the winnings, a utility function defined on the space of the winnings, and a transformation of the utilities of the winnings. The main attempts at a solution of the Petersburg Paradox are labeled according to their most fervent proponents, viz. Bernoulli and Cramer, Buffon, and Menger. This paper also investigates the role of the probabilities for the Petersburg Paradox: they may well be used to solve a Petersburg Paradox, or to re-gain it by means of appropriate transformations. Thus, the probabilities are also instrumental for the Petersburg Paradox. The Petersburg Paradox can only be avoided for bounded utility functions. Its various solution proposals are but disguised attempts of filling in the missing behavioral justification for the boundedness of utility functions. This paper also corrects several misconceptions which have crept in the respective literature. -- |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:cauewp:201204&r=upt |
| By: | Jang, Tae-Seok; Sacht, Stephen |
| Abstract: | In this paper, we empirically examine a heterogenous bounded rationality version of a hybrid New-Keynesian model. The model is estimated via the simulated method of moments using Euro Area data from 1975Q1 to 2009Q4. It is generally assumed that agents' beliefs display waves of optimism and pessimism - so called animal spirits - on future movements in the output and inflation gap. Our main empirical findings show that a bounded rationality model with cognitive limitation provides fits for auto- and cross-covariances of the data which are slightly better than or equal to a model where rational expectations are assumed. This implies that the bounded rationality model provides some structural insights on the expectation formation process at the macro-level for the Euro Area. First, over the whole time interval the agents had expected moderate deviations of the future output gap from its steady state value with low uncertainty. Second, we find strong evidence for an autoregressive expectation formation process regarding the inflation gap. Both observations explain a high degree of persistence in the output gap and the inflation gap. |
| Keywords: | Animal Spirits; Bounded Rationality; Euro Area; New-Keynesian Model; Simulated Method of Moments |
| JEL: | E12 C53 E32 D83 |
| Date: | 2012–03–16 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:37399&r=upt |