nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2012‒05‒15
eleven papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Probabilistic Risk Attitudes and Local Risk Aversion: a Paradox By Vjollca Sadiraj
  2. The value of useless information By Larbi Alaoui
  3. Optimal Savings Taxation when Individuals have Different CRRA Utility Functions By Alan Krause
  4. Multidimensional Screening in a Monopolistic Insurance Market By Pau Olivella; Fred Schroyen
  5. Choice By Sequential Procedures By Jose Apesteguia; Miguel Angel Ballester
  6. A generalized unification theorem for choice theoretic foundations: Avoiding the necessity of pairs and triplets By He, Junnan
  7. Risk premium, variance premium and the maturity structure of uncertainty By Bruno Feunou; Jean-Sébastien; Abderrahim Taamouti; Roméo Tédongap
  8. Are Self-regarding Subjects More Rational? By Benito Arruñada; Marco Casari; Francesca Pancotto
  9. Coping with Systemic Risk in Index-based Crop Insurance By Shen, Zhiwei; Odening, Martin
  10. Quotient Spaces of Boundedly Rational Types By Davide Cianciaruso; Fabrizio Germano
  11. Alternative Modeling for Long Term Risk By Dominique Guegan; Xin Zhao

  1. By: Vjollca Sadiraj
    Abstract: Prominent theories of decision under risk that challenge expected utility theory model risk attitudes at least partly with transformation of probabilities. This paper shows how attributing local risk aversion (partly or wholly) to attitudes towards probabilities can produce extreme probability distortions that imply paradoxical risk aversion.
    Keywords: risk aversion, probability transformation, calibration
    JEL: D81
    Date: 2012–05
  2. By: Larbi Alaoui
    Abstract: There are many situations in which individuals have a choice of whether or not to observe eventual outcomes. In these instances, individuals often prefer to remain ignorant. These contexts are outside the scope of analysis of the standard von Neumann-Morgenstern (vNM) expected utility model, which does not distinguish between lotteries for which the agent sees the nal outcome and those for which he does not. I develop a simple model that admits preferences for making an observation or for remaining in doubt. I then use this model to analyze the connection between preferences of this nature and risk-attitude. This framework accommodates a wide array of behavioral patterns that violate the vNM model, and that may not seem related, prima facie. For instance, it admits self-handicapping, in which an agent chooses to impair his own performance. It also accommodates a status quo bias without having recourse to framing e effcts, or to an explicit definition of reference points. In a political economy context, voters have strict incentives to shield themselves from information. In settings with other-regarding preferences, this model predicts observed behavior that seems inconsistent with either altruism or self-interested behavior.
    Keywords: value of information, uncertainty, recursive utility, doubt, unobserved outcomes, unresolved lotteries
    JEL: D03 D80 D81 D64
    Date: 2012–04
  3. By: Alan Krause
    Abstract: Recent empirical research has found that high-skill individuals tend to be less risk averse than low-skill individuals, which implies that their respective constant relative risk aversion (CRRA) utility functions have different curvature. This paper examines the effects of this form of preference heterogeneity on the classic question of whether taxing savings is desirable when the government also implements optimal nonlinear income taxation. It is shown that taxing or subsidising savings may be optimal, even if labour is separable from consumption in the utility function. Specifically, if the individuals' discount rate is lower (resp. higher) than the market interest rate, it is optimal to tax (resp. subsidise) savings. If the individuals' discount rate is equal to the market interest rate, zero taxation of savings is optimal. This basic relationship holds under both linear and nonlinear taxation of savings.
    Keywords: Savings taxation; nonlinear income taxation; preference heterogeneity.
    JEL: H21 H24
    Date: 2012–05
  4. By: Pau Olivella; Fred Schroyen
    Abstract: In this paper, we consider a population of individuals who differ in two dimensions: their risk type (expected loss) and their risk aversion. We solve for the profit maximizing menu of contracts that a monopolistic insurer puts out on the market. First, we find that it is never optimal to fully separate all the types. Second, if heterogeneity in risk aversion is sufficiently high, then some high-risk individuals (the risk-tolerant ones) will obtain lower coverage than some low-risk individuals (the risk-averse ones). Third, we show that when the average man and woman differ only in risk aversion, gender discrimination may lead to a Pareto improvement.
    Keywords: insurance markets, asymmetric information, screening, gender discrimination, positive correlation test
    JEL: D82 G22
    Date: 2012–02
  5. By: Jose Apesteguia; Miguel Angel Ballester
    Abstract: We propose a rule of decision-making, the sequential procedure guided by routes, and show that three influential boundedly rational choice models can be equivalently understood as special cases of this rule. In addition, the sequential procedure guided by routes is instrumental in showing that the three models are intimately related. We show that choice with a status-quo bias is a refinement of rationalizability by game trees, which, in turn, is also a refinement of sequential rationalizability. Thus, we provide a sharp taxonomy of these choice models, and show that they all can be understood as choice by sequential procedures.
    Keywords: individual rationality, bounded rationality, behavioral economics
    JEL: D01
    Date: 2012–03
  6. By: He, Junnan
    Abstract: This paper is concerned with the axiomatic foundation of the revealed preference theory. Many well-known results in literature rest upon the ability to choose over budget sets that contains only 2 or 3 elements, the situations which are not observable in real life. In order to give a more realistic approach, this paper shows that many of the famous consistency requirements, such as those proposed by Arrow, Sen, Samuelson etc., are equivalent if the domain of choice functions satisfy some set theoretical properties. And these properties, unions and inclusions for example, are proposed in a way that gives observability. --
    Keywords: Revealed preference theory,rationality,preference,choice functions
    JEL: B00 C00 D01 D11
    Date: 2012
  7. By: Bruno Feunou; Jean-Sébastien; Abderrahim Taamouti; Roméo Tédongap
    Abstract: Theoretical risk factors underlying time-variations of risk premium across asset classes are typically unobservable or hard to measure by construction. Important examples include risk factors in Long Run Risk [LRR] structural models (Bansal and Yaron 2004) as well as stochastic volatility or jump intensities in reduced-form affine representations of stock returns (Duffie, Pan, and Singleton 2000). Still, we show that both classes of models predict that the term structure of risk-neutral variance should reveal these risk factors. Empirically, we use model-free measures and construct the ex-ante variance term structure from option prices. This reveals (spans) two risk factors that predict the bond premium and the equity premium, jointly. Moreover, we find that the same risk factors also predict the variance premium. This important contribution is consistent with theory and confirms that a small number of factors underlies common time-variations in the bond premium, the equity premium and the variance premium. Theory predicts that the term structure of higher-order risks can reveal the same factors. This is confirmed in the data. Strikingly, combining the information from the variance, skewness and kurtosis term structure can be summarized by two risk factors and yields similar level of predictability (i.e., R2s). This bodes well for our ability to bridge the gap between the macro-finance literature, which uses very few state variables, and valuations in option markets.
    Keywords: Equity premium, Bond premium, Variance premium, Term structure, Variance, Skewness, Kurtosis, Long-run risks
    JEL: C22 G12 G17
    Date: 2011–11
  8. By: Benito Arruñada; Marco Casari; Francesca Pancotto
    Abstract: Through an experiment, we investigate how the level of rationality relates to concerns for equality and efficiency. Subjects perform dictator games and a guessing game. More rational subjects are not more frequently of the self-regarding type. When performing a comparison within the same degree of rationality, self-regarding subjects show more strategic sophistication than other subjects.
    Keywords: steps of reasoning, other-regarding preferences
    JEL: C91 C92 D63
    Date: 2012–01
  9. By: Shen, Zhiwei; Odening, Martin
    Abstract: The implementation of index-based crop insurance is often impeded by the existence of systemic risk of insured losses. We assess the effectiveness of two strategies for coping with systemic risk: regional diversification and securitization with catastrophe (CAT) bonds. The analysis is conducted in an equilibrium pricing framework which allows the optimal price of the insurance and the number of traded contracts to be determined. We also explore the role of basis risk and risk aversion of market agents. The model is applied to a hypothetical area yield insurance for rice producers in northeast China. If yields in two regions are positively correlated, we find that enlarging the insured area leads to an increasing insurance premium. Unless capital market investors are very risk averse, a CAT bond written on an area yield index outperforms regional diversification in terms of certainty equivalents of both farmers and insurers.
    Keywords: crop insurance, systemic risk, risk pooling, securitization, Risk and Uncertainty, Q11, Q14,
    Date: 2012–02–23
  10. By: Davide Cianciaruso; Fabrizio Germano
    Abstract: By identifying types whose low-order beliefs up to level ℓ<sub>i</sub> about the state of nature coincide, we obtain quotient type spaces that are typically smaller than the original ones, preserve basic topological properties, and allow standard equilibrium analysis even under bounded reasoning. Our Bayesian Nash (ℓ<sub>i</sub>; ℓ<sub>ii</sub>)-equilibria capture players inability to distinguish types belonging to the same equivalence class. The case with uncertainty about the vector of levels (ℓ<sub>i</sub>; ℓ<sub>ii</sub>) is also analyzed. Two examples illustrate the constructions.
    Keywords: Incomplete-information games, high-order reasoning, type space, quotient space, hierarchies of beliefs, bounded rationality
    JEL: C72 D03 D83
    Date: 2011–09
  11. By: Dominique Guegan (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon Sorbonne, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris); Xin Zhao (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon Sorbonne)
    Abstract: In this paper, we propose an alternative approach to estimate long-term risk. Instead of using the static square root method, we use a dynamic approach based on volatility forecasting by non-linear models. We explore the possibility of improving the estimations by different models and distributions. By comparing the estimations of two risk measures, value at risk and expected shortfall, with different models and innovations at short, median and long-term horizon, we find out that the best model varies with the forecasting horizon and the generalized Pareto distribution gives the most conservative estimations with all the models at all the horizons. The empirical results show that the square root method underestimates risk at long horizon and our approach is more competitive for risk estimation at long term.
    Keywords: Long memory, Value at Risk, expect shortfall, extreme value distribution.
    Date: 2012–04

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