nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2012‒07‒08
seventeen papers chosen by
Alexander Harin
Modern University for the Humanities

  1. Parametric Recoverability of Preferences By Halevy, Yoram
  2. Accounting for farmers’ risk preferences in investigating land allocation decisions in marginal environments: a test of various elicitation measures in an application from Vietnam By Keil, Alwin; Nielsen, Thea
  3. Risk Attitude, Beliefs, and Information in a Corruption Game - An Experimental Analysis By Siegfried K. Berninghaus; Sven Haller; Tyll Krüger; Thomas Neumann; Stephan Schosser; Bodo Vogt
  4. A Utility Framework for Bounded-Loss Market Makers By Yiling Cheng; David M Pennock
  5. Maximizing Utility of Consumption Subject to a Constraint on the Probability of Lifetime Ruin By Erhan Bayraktar; Virginia R. Young
  6. Estimating probability distributions of future asset prices: empirical transformations from option-implied risk-neutral to real-world density functions By de Vincent-Humphreys, Rupert; Noss, Joseph
  7. Risk-sharing or risk-taking? Counterparty risk, incentives and margins By Bruno Biais; Florian Heider; Marie Hoerova
  8. Reciprocal Deposits and Incremental Bank Risk By Sherrill Shaffer
  9. Time Consistency: Stationarity and Time Invariance By Halevy, Yoram
  10. Shannon's measure of information, path averages and the origins of random utility models in transport itinerary or mode choice analysis By Marc Gaudry; Emile Quinet
  11. Do Jumps Contribute to the Dynamics of the Equity Premium? By John M. Maheu; Thomas H. McCurdy; Xiaofei Zhao
  12. Liquidity and credit risk premia in government bond yields By Jacob Ejsing; Magdalena Grothe; Oliver Grothe
  13. Estimating C-CAPM and the Equity Premium over the Frequency Domain By Ekaterini Panopoulou; Sarantis Kalyvitis
  14. The Economics of Options-Implied Inflation Probability Density Functions By Yuriy Kitsul; Jonathan H. Wright
  15. Estimation of discount factor (beta) and coefficient of relative risk aversion (gamma) in selected countries By Ahmed, Waqas; Haider, Adnan; Iqbal, Javed
  16. International Capital Mobility and Financial Fragility - Part 5. Do Investors Disproportionately Shed Assets of Distant Countries Under Increased Uncertainty?: Evidence from the Global Financial Crisis By OECD
  17. Forecasting U.S. Housing Starts Under Asymmetric Loss By Christian , Pierdzioch; Rülke, Jan-Christoph; Stadtmann, Georg

  1. By: Halevy, Yoram
    Abstract: We propose a procedure to recover parametric preferences from choices made from convex budget sets. The objective of the method is to minimize the inconsistency between the revealed preference information contained in the choices and the ranking information contained in the recovered preferences. For a given parametric utility function the procedure calculates, for every choice, the minimal proportional adjustment to the budget such that the two rankings are aligned. The closest element in a parametric family is found by minimizing a metric that is based on these minimal adjustments. Additionally, we show that this method can be used to recover approximate preferences even for inconsistent decision makers. The goodness of ï¬t of such approximation can be decomposed into a familiar measure of inconsistency and a natural measure of misspeciï¬cation. This decomposition provides a reasonable way to test restrictions and to select among different parametric models. We apply this method to a data set constructed in a lab experiment on choice under risk. The recovered utility structure(within the same parametric family) exhibits, on average, higher ï¬rst-order risk aversion (non-expected utility) and lower second-order risk aversion (expected utility), thanthe standard method that is based on statistical distance.
    Keywords: Revealed Preference, Recoverability of Preferences, GARP, non-expected utility, risk aversion
    Date: 2012–06–30
  2. By: Keil, Alwin; Nielsen, Thea
    Abstract: Smallholder farmers’ land allocation decisions in marginal areas of developing countries typically involve a substantial element of risk, especially when they concern input intensive cash crops. Hence, apart from farmers’ resource endowment, their individual level of risk aversion is a potentially important determinant of such decisions. However, in microeconometric models a measure of individuals’ risk preferences is usually lacking. We address this shortcoming by testing the explanatory power of a wide range of risk preference measures based on hypothetical and non-hypothetical elicitation methods in a model explaining land allocation to commercial hybrid maize production in a fragile upland area of Vietnam. Based on data collected in a random sample of 300 households, we find that the poorest farmers are particularly specialized in commercial maize production, but they are highly dependent on relatively disadvantageous input supply and marketing arrangements offered by maize traders, making this specialization particularly risky. Our study confirms the relevance of decision-makers’ risk preferences in addition to their asset endowment in the land allocation decision. The inclusion of risk preference measures as explanatory variables is found to not cause any significant endogeneity bias. However, only risk preference measures that are based on hypothetical maize related scenarios have explanatory power. We conclude that (1) risk preferences are to a certain extent decision domain specific and (2) hypothetical scenarios that are closely related to farmers’ real-life decisions may produce more reliable results than unfamiliar, non-agricultural scenarios or lottery-based methods, which may be difficult to grasp for respondents with limited formal education.
    Keywords: Risk preference elicitation, commercial maize production, marginal uplands, tobit regression, Vietnam, Farm Management, Research Methods/ Statistical Methods, Risk and Uncertainty, C93, D81,
    Date: 2012
  3. By: Siegfried K. Berninghaus (Karlsruhe Institute of Technology (KIT), Institute for Economic Theory and Statistics); Sven Haller (Otto-von-Guericke-University Magdeburg, Faculty of Economics and Management); Tyll Krüger (University of Bielefeld, Research Center BiBoS); Thomas Neumann (Otto-von-Guericke-University Magdeburg, Faculty of Economics and Management); Stephan Schosser (Otto-von-Guericke-University Magdeburg, Faculty of Economics and Management); Bodo Vogt (Otto-von-Guericke-University Magdeburg, Faculty of Economics and Management)
    Abstract: For our experiment on corruption, we designed a coordination game to model the influence of risk attitudes, beliefs, and information on behavioral choices and determined the equilibria. We observed that the participants' risk attitudes failed to explain their choices between corrupt and non-corrupt behavior. Instead, beliefs appeared to be a better predictor of whether or not they would opt for the corrupt alternative. Furthermore, varying the quantity of information available to players (modeled by changing the degree of uncertainty) provided additional insight into the players' propensity to engage in corrupt behavior. The experimental results show that a higher degree of uncertainty in the informational setting reduces corruption.
    Keywords: Corruption, game theory, experiment, risk attitude, beliefs
    JEL: D73 K42 C91 C92
    Date: 2012–07–02
  4. By: Yiling Cheng; David M Pennock
    Abstract: We introduce a class of utility-based market makers that always accept orders at their risk-neutral prices. We derive necessary and sufficient conditions for such market makers to have bounded loss. We prove that hyperbolic absolute risk aversion utility market makers are equivalent to weighted pseudospherical scoring rule market makers. In particular, Hanson's logarithmic scoring rule market maker corresponds to a negative exponential utility market maker in our framework. We describe a third equivalent formulation based on maintaining a cost function that seems most natural for implementation purposes, and we illustrate how to translate among the three equivalent formulations. We examine the tradeoff between the market's liquidity and the market maker's worst-case loss. For a fixed bound on worst-case loss, some market makers exhibit greater liquidity near uniform prices and some exhibit greater liquidity near extreme prices, but no market maker can exhibit uniformly greater liquidity in all regimes. For a fixed minimum liquidity level, we give the lower bound of market maker's worst-case loss under some regularity conditions.
    Date: 2012–06
  5. By: Erhan Bayraktar; Virginia R. Young
    Abstract: In this note, we explicitly solve the problem of maximizing utility of consumption (until the minimum of bankruptcy and the time of death) with a constraint on the probability of lifetime ruin, which can be interpreted as a risk measure on the whole path of the wealth process.
    Date: 2012–06
  6. By: de Vincent-Humphreys, Rupert (Bank of England); Noss, Joseph (Bank of England)
    Abstract: The prices of derivatives contracts can be used to estimate ‘risk-neutral’ probability density functions that give an indication of the weight investors place on different future prices of their underlying assets, were they risk-neutral. In the likely case that investors are risk-averse, this leads to differences between the risk-neutral probability density and the actual distribution of prices. But if this difference displays a systematic pattern over time, it may be exploited to transform the risk-neutral density into a ‘real-world’ density that better reflect agents’ actual expectations. This work offers a methodology for performing this transformation. The resulting real-world densities may better represent market participants’ views of future prices, and so offer an enhanced means of quantifying the uncertainty around financial variables. Comparison with their risk-neutral equivalents may also reveal new and useful information as to how attitudes towards risk are affecting pricing.
    Keywords: Asset prices; derivatives; expectations; options; option-implied density; risk premia; probability density forecasting; probability measure
    JEL: G10 G12 G13
    Date: 2012–06–21
  7. By: Bruno Biais (Toulouse School of Economics (CNRS-CRM, IDEI), 21 Allée de Brienne, 31000 Toulouse, France.); Florian Heider (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Marie Hoerova (European Central Bank, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.)
    Abstract: We analyze optimal hedging contracts and show that although hedging aims at sharing risk, it can lead to more risk-taking. News implying that a hedge is likely to be loss-making undermines the risk-prevention incentives of the protection seller. This incentive problem limits the capacity to share risks and generates endogenous counterparty risk. Optimal hedging can therefore lead to contagion from news about insured risks to the balance sheet of insurers. Such endogenous risk is more likely to materialize ex post when the ex ante probability of counterparty default is low. Variation margins emerge as an optimal mechanism to enhance risk-sharing capacity. Paradoxically, they can also induce more risk-taking. Initial margins address the market failure caused by unregulated trading of hedging contracts among protection sellers. JEL Classification: G21, G22, D82.
    Keywords: Insurance, moral hazard, counterparty risk, margin requirements, derivatives.
    Date: 2012–01
  8. By: Sherrill Shaffer
    Abstract: Even after controlling for other observable factors, reciprocal deposits are associated with higher bank risk as measured by the probability of failure and the Zscore. These results are consistent with the moral hazard hypothesis and reject the risk substitution hypothesis.
    JEL: G21
    Date: 2012–06
  9. By: Halevy, Yoram
    Abstract: A sequence of experiments documents static and dynamic "preference reversals" between sooner-smaller and later-larger rewards, when the sooner reward could be immediate. The theoretically-motivated design permits separate identification of time-consistent, stationary and time-invariant choices. Half of the subjects are time consistent, but only two-thirds of them exhibit stationary choices. About half of subjects with time inconsistent choices have stationary preferences. These results challenge the view that present-bias preferences are the main source of time inconsistent choices.
    Keywords: Discounting, dynamic consistency, present bias, stability
    JEL: D03 D81 D91 C91
    Date: 2012–06–24
  10. By: Marc Gaudry (AJD - Agora Jules Dupuit - Université de Montréal - Département de sciences économiques); Emile Quinet (PSE - Paris-Jourdan Sciences Economiques - CNRS : UMR8545 - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - Ecole des Ponts ParisTech - Ecole Normale Supérieure de Paris - ENS Paris - INRA, EEP-PSE - Ecole d'Économie de Paris - Paris School of Economics - Ecole d'Économie de Paris)
    Abstract: We interpret the often mentioned difference between Logsum and average utility in terms of Shannon's (1948) information measure S, leading to a Path Aggregation THeorem (PATH). It states that, in transport networks where unique measures of the utility of multiple paths are required for demand model formulation purposes and the true path choice model is Multinomial Logit (MNL), constructs based on weighted averages of path characteristics derived from multipath assignments always underestimate the utility of multiple paths, a deficit exactly equal to S (corresponding to minus-one times entropy) if the weights are the path choice probabilities. We study the properties of this S measure of aggregation error, along with those arising from other types of averages of path characteristics, outlining some implications for demand estimation and project appraisal. Notably, the validity of the PATH does not depend on the specific contents of the representative utility functions (RUF) associated to paths, such as their mathematical form or their eventual inclusion of alternative-generic constants (AGC). We show by simulation that averaging modes or sub-modes ― a frequent feature of traffic modeling studies ― can lead to important error in terms of level of traffic and welfare measurement. Concerning the mathematical form of the RUF, we recall that, after the publication of Abraham's 1961 random utility model (RUM) of road path choice deriving the Probit specification based on the Gaussian error distribution (and another specification based on the Rectangular error distribution), French engineers used this seminal approach as justification of road path choice formulae then in current use and assigned the name "Abraham's Law" to a particular standard one, effectively a "Logarithmic Logit" close to the logarithmic RUF carefully specified for Logit mode choice by Warner in 1962. For transit problems, the preference went to a linear RUF, as evidenced in Barbier's casual binomial Probit application to bus and metro, published in 1966, which may have inspired the later generalizations by Domencich and McFadden. In view of many founders' conscientiously crafted nonlinear Logit formulations, and more generally of the repeatedly demonstrated presence of nonlinearity in RUF path and mode specifications since their careful work 50 years ago, we analyze the impact of such nonlinearity on S. This impact is tractable through a comparison of measures S2 and S1 associated with two path choice models differing only in RUF form, as determined by Box-Cox transformations applied to their level-of-service (LOS) variables. We show that, although the difference between measures S2 and S1 may reach a minimum or a maximum with changes in LOS, the solution for such a turning point cannot be established analytically but requires numerical methods: the demonstrable impact on S of nonlinearity, or asymmetry of Logit curve response, is tractable, but only at non trivial computational cost. We point out that the path aggregation issue, whereby aggregation of paths by Logsums differs from aggregation of their characteristics by averages, is not limited to public transit (PT) projects with more or less "common" lines competing in dense urban transit networks (our particular Paris predicament motivating the analysis) but also arises in other modes whenever distinct itineraries or lines compete within a single mode. Concerning dense urban PT networks, we hypothesize that Logsums based on multiple path assignments treating all transit means (about 10 in our problem) as one modal network should, using Ockham's razor, be simpler than the insertion of a layer of choice hierarchies among such urban means based on non nested specifications embodying assumptions on the identity of "higher" and "lower" means, the latter reasserting the multiple path access problems the hierarchies were designed to solve in the first place. Concerning road networks, the proper accounting of multiple path use to avoid Shannon aggregation error points to an abandonment of Wardrop's equilibrium in favor of Logit choice. This completed shift should favor transit when it is the minority mode.
    Keywords: Multipath assignment ; Aggregation of path characteristics ; Path aggregation ; Inclusive values ; Multinomial Logit ; Shannon's measure of information ; Origins of Random Utility Models (RUM) ; Probit ; Logarithmic Logit ; Abraham's Law of traffic assignment ; Kirchhoff's distribution ; Non linearity of Representative Utility Functions (RUF) ; Box-Cox transformations (BCT) ; French engineers ; Claude Abraham ; Stanley Warner ; Michel Barbier ; Robert Fogel ; Daniel McFadden ; Abraham-McFadden approach ; EOLE ; Paris RER E westerly extension ; Public Transit (PT) assignment ; transit hierarchies ; SAMPERS ; PRISM ; CUBE Voyager ; VISUM ; NODUS
    Date: 2012–06
  11. By: John M. Maheu (Department of Economics, University of Toronto, Canada; RCEA, Italy); Thomas H. McCurdy (Rotman School of Managment, University of Toronto, Canada; CIRANO, Canada); Xiaofei Zhao (Rotman School of Management, University of Toronto, Canada)
    Abstract: This paper investigates whether risks associated with time-varying arrival of jumps and their effect on the dynamics of higher moments of returns are priced in the conditional mean of daily market excess returns. We find that jumps and jump dynamics are significantly related to the market equity premium. The results from our time-series approach reinforce the importance of the skewness premium found in cross-sectional studies using lower-frequency data; and offer a potential resolution to sometimes conflicting results on the intertemporal risk-return relationship. We use a general utility specification, consistent with our pricing kernel, to evaluate the relative value of alternative risk premium models in an out-of-sample portfolio performance application.
    JEL: C22 C58 G10
    Date: 2012–06
  12. By: Jacob Ejsing (Danmarks Nationalbank, Government Debt Management, Havnegade 5, DK-1093 Copenhagen, Denmark.); Magdalena Grothe (European Central Bank, Directorate General Economics, Capital Markets and Financial Structure Division, Kaiserstrasse 29, D-60311 Frankfurt am Main, Germany.); Oliver Grothe (University of Cologne, Department of Economic and Social Statistics, Albertus-Magnus-Platz, D-50923 Cologne, Germany.)
    Abstract: This paper quantifies liquidity and credit premia in German and French government bond yields. For this purpose, we estimate term structures of governmentguaranteed agency bonds and exploit the fact that any difference in their yields vis-`a-vis government bonds can be attributed to differences in liquidity premia. Adding the information on risk-free rates, we obtain model-free and model-based gauges of sovereign credit premia, which are an important alternative to the information based on CDS markets. The results allow us to quantify the price impact of so-called “safe haven flows”, which strongly affected bond markets in late 2008/early 2009 and again during some phases of the sovereign debt crisis. Thus, we show to what extent these effects disguised the increase of sovereign credit premia in the government yields of core euro area countries. JEL Classification: E44; G12; G01.
    Keywords: liquidity premium; sovereign credit risk; yield curve modeling; bond markets; state space models.
    Date: 2012–06
  13. By: Ekaterini Panopoulou (University of Piraeus); Sarantis Kalyvitis (DIEES, AUEB)
    Abstract: In this paper we estimate the single-factor Consumption Capital Asset Pricing Model (C-CAPM) over the frequency domain. We modify the standard two-step methodology (Fama and French, 1992) to account for the spectral properties of consumption risk and we find that its lower frequencies explain up to 98% of the cross-sectional variation of expected returns and that the equity premium puzzle is eliminated. These results are robust to the definitions of the variables, the sample span and the set of portfolios utilized, and the maturity of interest rates.
    Keywords: C-CAPM, consumption risk, frequency domain, equity premium
    JEL: G11 G12 C13
    Date: 2012–06–28
  14. By: Yuriy Kitsul; Jonathan H. Wright
    Abstract: Recently a market in options based on CPI inflation (inflation caps and floors) has emerged in the US. This paper uses quotes on these derivatives to construct probability densities for inflation. We study how these pdfs respond to news announcements, and find that the implied odds of deflation are sensitive to certain macroeconomic news releases. We compare the option-implied probability densities with those obtained by time series methods, and use this information to construct empirical pricing kernels. The options-implied densities assign considerably more mass to extreme inflation outcomes (either deflation or high inflation) than do their time series counterparts. This yields a U-shaped empirical pricing kernel, with investors having high marginal utility in states of the world characterized by either deflation or high inflation.
    JEL: C22 E31 E44 G12
    Date: 2012–06
  15. By: Ahmed, Waqas; Haider, Adnan; Iqbal, Javed
    Abstract: We estimate the long-run discount factor for a group of developed and developing countries through standard methodology incorporating adaptive expectations of inflation. We find that the discount factor of developing countries is relatively nearer to unity as compared to that of the developed countries. In the second part, while considering a standard Euler equation for household's intertemporal consumption, we estimate the parameter of constant relative risk aversion (CRRA) for Pakistan by using the Generalized Method of Moments (GMM) approach. The resulting parameter value of CRRA confirms to the empirical range for developing countries (as given in, Cardenas and Carpenter, 2008). The GMM estimator for the discount factor reinforces its result from the first part of the paper. Consequently we show that different combination values for both the parameters result in different (in terms of magnitude) impulse response functions, in response to tight monetary policy shocks in a simple New Keynesian macroeconomic model.
    Keywords: Discount Factor; Risk Aversion; Euler Equation; GMM
    JEL: C13 D91 E21
    Date: 2012–06–29
  16. By: OECD
    Abstract: The global crisis of 2008-09 went in hand with sharp fluctuations in capital flows. To some extent, these fluctuations may have been attributable to uncertainty-averse investors indiscriminately selling assets about which they had poor information, including those in geographically distant locations. Using a gravity equation setup, this paper shows that the impact of distance increases with investors’ uncertainty aversion. Consistent with a sudden increase in uncertainty, the negative impact of distance on foreign holdings increased during the global financial crisis of 2008-09. Host-country structural policies enhancing the quality of information available to foreign investors, such as strict disclosure requirements and prudential bank regulation, tended to mitigate withdrawals.<P>Flux de capitaux internationaux et fragilité financière : Partie 5. Les investisseurs se séparent-ils surtout des actifs des pays géographiquement distants en période d'incertitude ? Évidence empirique pendant la crise financière globale<BR>2 ABSTRACT/RÉSUMÉ International capital mobility and financial fragility: Part 5. Do investors disproportionately shed assets of distant countries under increased uncertainty? Evidence from the global financial crisis The global crisis of 2008-09 went in hand with sharp fluctuations in capital flows. To some extent, these fluctuations may have been attributable to uncertainty-averse investors indiscriminately selling assets about which they had poor information, including those in geographically distant locations. Using a gravity equation setup, this paper shows that the impact of distance increases with investors’ uncertainty aversion. Consistent with a sudden increase in uncertainty, the negative impact of distance on foreign holdings increased during the global financial crisis of 2008-09. Host-country structural policies enhancing the quality of information available to foreign investors, such as strict disclosure requirements and prudential bank regulation, tended to mitigate withdrawals. JEL classification codes: F21; G11; G18 Keywords: Capital flows; gravity model; uncertainty; crisis; financial regulation ************************************ Flux de capitaux internationaux et fragilité financière : Partie 5. Les investisseurs se séparent-ils surtout des actifs des pays géographiquement distants en période d’incertitude ? Évidence empirique pendant la crise financière globale La crise globale de 2008-09 a été accompagnée par de brusques fluctuations des flux de capitaux. Ces fluctuations pourraient être liées à la vente indiscriminée par des investisseurs averses à l’incertitude des actifs sur lesquels ils possédaient peu d’information, dont les actifs situés dans les pays géographiquement éloignés. Ce papier démontre dans le cadre d’une équation de gravité que l’impact de la distance sur la détention d’actifs internationaux augmente avec l’aversion à l’incertitude des investisseurs. Cet impact négatif de la distance sur la détention d’actifs a augmenté pendant la crise financière globale de 2008-09, ce qui est cohérent avec une soudaine augmentation de l’incertitude. Les politiques structurelles dans le pays de destination qui permettent aux investisseurs d’avoir accès à une information de meilleure qualité, comme par exemple de strictes obligations de divulgations des résultats et la régulation prudentielle des banques, ont eu tendance à réduire les retraits de capitaux des investisseurs étrangers.
    JEL: F21 G11 G18
    Date: 2012–06–12
  17. By: Christian , Pierdzioch (Helmut Schmidt University, Hamburg); Rülke, Jan-Christoph (WHU – Otto Beisheim School of Management,); Stadtmann, Georg (Europa-Universität Viadrina)
    Abstract: Survey data of forecasts of the housing market may provide a particularly rich data nvironment for researchers and policymakers to study developments in housing markets. Based on the approach advanced by Elliott et al. (Rev. Ec. Studies. 72, 1197-1125, 2005), we studied the properties of a large set of survey data of housing starts in the United States. We document the heterogeneity of forecasts, analyze the shape of forecasters’ loss function, study the rationality of forecasts, and the temporal variation in forecasts.
    Keywords: Housing starts; Loss function; Rationality of forecasts
    JEL: D84
    Date: 2012–06–27

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