|
on Utility Models and Prospect Theory |
| By: | Gwenola Trotin (Aix-Marseille University (Aix-Marseille School of Economics), CNRS & EHESS) |
| Abstract: | This paper examines the determinants of tax evasion under prospect theory. For prospect theory, reference dependence is a fundamental element (the utility function depends on gains and losses relative to a reference point and not on final wealths as in expected utility theory). In order to identify the determinants of the income tax evasion decision, a general reference income is used. We show that results obtained under expected utility theory are not robust. In particular, tax evasion is increasing in the tax rate as soon as a suitable relative risk aversion measure is larger with auditing, than without. With this simple and testable condition, prospect theory provides a general framework consistent with empirical evidence for the tax evasion behaviour problem. |
| Keywords: | Tax evasion; Prospect theory; Reference dependence; Decision weights. |
| JEL: | D81 H26 K42 |
| Date: | 2012–09–03 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1238&r=upt |
| By: | Ani Guerdjikova; Jürgen Eichberger (THEMA, Universite de Cergy-Pontoise and THEMA; University of Heidelberg) |
| Abstract: | In this paper we suggest a behavioral approach to decision making under ambiguity based on available information. A decision situation is characterized by a set of actions, a set of outcomes, and data consisting of action-outcome pairs. Decision-makers express preferences over actions and data sets. We derive a representation of preferences, which separates utility and beliefs. While the utility function is purely subjective, the beliefs of the decision maker combine objective characteristics of the data (number and frequency of observations) with subjective features of the decision maker (similarity of observations and perceived ambiguity). We identify the subjectively perceived degree of ambiguity and separate it into ambiguity due to a limited number of observations and ambiguity due to data heterogeneity. We also determine the decision maker’s attitude towards ambiguity. The special case of no ambiguity represents beliefs as similarity-weighted frequencies and provides a behavioral foundation for Billot, Gilboa, Samet and Schmeidler’s (2005) representation. |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:ema:worpap:2012-45&r=upt |
| By: | Martina Nardon (Department of Economics, University Of Venice Cà Foscari); Paolo Pianca (pianca@unive.it) |
| Abstract: | Empirical studies on quoted options highlight deviations from the theoretical model of Black and Scholes; this is due to different causes, such as assumptions regarding the price dynamics, markets frictions and investors' attitude toward risk. In this contribution, we focus on this latter issue and study how to value European options within the continuous cumulative prospect theory. According to prospect theory, individuals do not always take their decisions consistently with the maximization of expected utility. Decision makers have biased probability estimates; they tend to underweight high probabilities and overweight low probabilities. Risk attitude, loss aversion and subjective probabilities are described by two functions: a value function and a weighting function, respectively. In our analysis, we use alternative probability weighting functions. We consider the pricing problem both from the writer's and holder's perspective, obtaining an interval for the prices of call and put options. |
| Keywords: | Behavioral Finance, Cumulative Prospect Theory, European Option Pricing. |
| JEL: | C63 D81 G13 |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:ven:wpaper:2012:34&r=upt |
| By: | Lahno, Amrei M.; Serra-Garcia, Marta |
| Abstract: | This paper examines the effect of peers on individual risk taking. In the absence of informational motives, we investigate why social utility concerns may drive peer effects. We test for two main channels: utility from payoff differences and from conforming to the peer. We show experimentally that social utility generates substantial peer effects in risk taking. These are mainly explained by utility from payoff differences, in line with outcomebased social preferences. Contrary to standard assumptions, we show that estimated social preference parameters change significantly when peers make active choices, compared to when lotteries are randomly assigned to them. |
| Keywords: | Peer Effects; Decision Making under risk; Social Comparison; Social Preferences; Laboratory Experiment |
| JEL: | C91 C92 D03 D83 |
| Date: | 2012–12 |
| URL: | http://d.repec.org/n?u=RePEc:lmu:muenec:14309&r=upt |
| By: | Paolo Crosetto; Antonio Filippin |
| Abstract: | This paper presents the Bomb Risk Elicitation Task (BRET), an intuitive procedure aimed at measuring risk attitudes. Subjects decide how many boxes to collect out of 100, one of which containing a bomb. Earnings increase linearly with the number of boxes accumulated but are zero if the bomb is also collected. The BRET requires minimal numeracy skills, avoids truncation of the data, allows to precisely estimate both risk aversion and risk seeking, and is not affected by the degree of loss aversion or by violations of the Reduction Axiom. We validate the BRET and test its robustness in a large-scale experiment, although the task can be performed in the field as well. Choices react significantly to the stakes and to the size of the choice set. Our experiment rationalizes the gender gap that often characterizes choices under uncertainty by means of a higher loss rather than risk aversion. |
| Keywords: | Risk Aversion, Loss Aversion, Elicitation Method |
| JEL: | C81 C91 D81 |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:diw:diwsop:diw_sp517&r=upt |
| By: | Nina Boyarchenko; Mario Cerrato; John Crosby; Stewart Hodges |
| Abstract: | Faced with the problem of pricing complex contingent claims, investors seek to make their valuations robust to model uncertainty. We construct a notion of a model-uncertainty-induced utility function and show that model uncertainty increases investors’ effective risk aversion. Using this utility function, we extend the “no good deals” methodology of Cochrane and Saá-Requejo (2000) to compute lower and upper good-deal bounds in the presence of model uncertainty. We illustrate the methodology using some numerical examples. |
| Keywords: | Investments ; Econometric models ; Uncertainty ; Asset pricing |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fednsr:589&r=upt |
| By: | Xiaohong Chen (Cowles Foundation, Yale University); Jack Fuvilukis (Dept. of Finance, London School of Economics); Sydney Ludvigson (Dept. of Economics, New York University) |
| Abstract: | This paper presents estimates of key preference parameters of the Epstein and Zin (1989, 1991) and Weil (1989) (EZW) recursive utility model, evaluates the model's ability to fit asset return data relative to other asset pricing models, and investigates the implications of such estimates for the unobservable aggregate wealth return. Our empirical results indicate that the estimated relative risk aversion parameter ranges from 17-60, with higher values for aggregate consumption than for stockholder consumption, while the estimated elasticity of intertemporal substitution is above one. In addition, the estimated model-implied aggregate wealth return is found to be weakly correlated with the CRSP value-weighted stock market return, suggesting that the return to human wealth is negatively correlated with the aggregate stock market return. |
| JEL: | G12 E21 |
| Date: | 2012–12 |
| URL: | http://d.repec.org/n?u=RePEc:cwl:cwldpp:1883&r=upt |
| By: | Fabrizio Zilibotti (University of Zurich); Matthias Doepke (Northwestern University) |
| Abstract: | We develop a theory of the intergenerational transmission of risk preferences. Parents can instill either risk tolerance or risk aversion in their children, and face both altruistic and paternalistic motives in this process. Risk-tolerant children are more likely to benefit from profitable but risky opportunities, such as the career choice of being an entrepreneur. However, risk-tolerant children may also engage in other risky choices (such as smoking or riding motorcycles) that the parents disagree with. In our model, the transmission of risk preferences feeds back into the growth rate of the economy, because risk-taking entrepreneurs are essential for endogenous technological innovation. The theory has implications for how the extent and nature of risk in the economic environment affects the transmission of risk preferences, entrepreneurship, and growth. |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed012:246&r=upt |
| By: | Sara Biagini; Jocelyne Bion-Nadal |
| Abstract: | We define Conditional quasi concave Performance Measures (CPMs), on random variables bounded from below, to accommodate for additional information. Our notion encompasses a wide variety of cases, from conditional expected utility and certainty equivalent to conditional acceptability indexes. We provide the characterization of a CPM in terms of an induced family of conditional convex risk measures. In the case of indexes these risk measures are coherent. Then, Dynamic Performance Measures (DPMs) are introduced and the problem of time consistency is addressed. The definition of time consistency chosen here ensures that the positions which are considered good tomorrow are already considered good today. We prove the equivalence between time consistency for a DPM and weak acceptance consistency for the induced families of risk measures. Finally, we extend CPMs and DPMs to dividend processes. |
| Date: | 2012–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1212.3958&r=upt |
| By: | Jonathan Wright (Johns Hopkins University); Yuriy Kitsul (Federal Reserve Board) |
| 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 announcments, and ÃÂfind 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. |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed012:174&r=upt |
| By: | Roger Myerson (University of Chicago) |
| Abstract: | We consider a simple overlapping-generations model with risk-averse financial agents subject to moral hazard. Efficient contracts for such financial intermediaries involve back-loaded late-career rewards. Compared to the analogous model with risk-neutral agents, risk aversion tends to reduce the growth of agents' responsibilities over their careers. This moderation of career growth rates can reduce the amplitude of the widest credit cycles, but it also can cause small deviations from steady state to amplify over time in rational-expectations equilibria. We find equilibria in which fluctuations increase until the economy enters a boom/bust cycle where no financial agents are hired in booms. |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed012:182&r=upt |
| By: | Fabrice Tricou |
| Abstract: | Rational choice theory stretches out in two complementary directions. Its contextual and extensive application fills and then overflows the strict domain of substantive economy, eventually identifying any human choice with an economic decision. Its structural and intensive sophistication surpasses the basic framework of choice without uncertainty to treat the exogenous and endogenous forms of uncertainty. These two forms of progress, thematic and analytical, come together to ensure the general expansion of the field of rational choice. Beyond its advantages and achievements, this attempt at universal “economization” faces limits in the two directions of its development. Contextually, the logic of instrumental choice is unable to grasp deontological morals and axiological rationality. And structurally, the logistics of rational choice is inoperative faced with a radically uncertain environment and/or a one-on-one interaction with another person. |
| Keywords: | rational choice theory, economics, interest, morals, uncertainty, market |
| JEL: | B40 D01 D80 C70 |
| Date: | 2012 |
| URL: | http://d.repec.org/n?u=RePEc:drm:wpaper:2012-50&r=upt |
| By: | A. Craig Burnside; Jeremy J. Graveline |
| Abstract: | Recent research in international finance has equated changes in real exchange rates with differences between the marginal utility growths of representative agents in different economies. The asset market view of exchange rates, encapsulated in this equation, has been used to gain insights into exchange rate determination, foreign exchange risk premia, and international risk sharing. We argue that, in fact, this equation is of limited usefulness. By itself, the asset market view does not identify the economic mechanism that determines the exchange rate. It only holds under complete markets, and even then, it does not generally allow us to identify the marginal utility growths of distinct agents. Moreover, if we allow for incomplete asset markets, measures of agents' marginal utility growths, and international risk sharing, cannot be based on asset market and exchange rate data alone. Instead, we argue that in order to explain how exchange rates are determined, it is necessary to make specific assumptions about preferences, goods market frictions, the assets agents can trade, and the nature of endowments or production. |
| JEL: | F31 G15 |
| Date: | 2012–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:18646&r=upt |
| By: | Nolan Miller; Alexander F. Wagner; Richard J. Zeckhauser |
| Abstract: | A principal provides budgets to agents (e.g., divisions of a firm or the principal's children) whose expenditures provide her benefits, either materially or because of altruism. Only agents know their potential to generate benefits. We prove that if the more "productive" agents are also more risk-tolerant (as holds in the sample of individuals we surveyed), the principal can screen agents and bolster target efficiency by offering a choice between a nonrandom budget and a two-outcome risky budget. When, at very low allocations, the ratio of the more risk-averse type's marginal utility to that of the other type is unbounded above (e.g., as with CRRA), the first-best is approached. -- A biblical opening enlivens the analysis. |
| JEL: | D82 G31 H12 |
| Date: | 2012–12 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:18634&r=upt |
| By: | Baojun Bian; Harry Zheng |
| Abstract: | In this paper we continue the study of Bian-Miao-Zheng (2011) and extend the results there to a more general class of utility functions which may be bounded and non-strictly-concave and show that there is a classical solution to the HJB equation with the dual control method. We then apply the results to study the efficient frontier of wealth and conditional VaR (CVaR) problem and the turnpike property problem. For the former we construct explicitly the optimal control and discuss the choice of the optimal threadshold level and illustrate that the wealth and the CVaR are positively correlated. For the latter we give a simple proof to the turnpike property of the optimal policy of long-run investors and generalize the results of Huang-Zariphopoulou (1999). |
| Date: | 2012–12 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1212.3137&r=upt |
| By: | Eizo Akiyama (Faculty of Engineering, Information and Systems. University of Tsukuba); Nobuyuki Hanaki (Ryuchiro Ishikawa); |
| Abstract: | We investigate the extent to which price deviations from fundamental values in an experimental asset market are due to the uncertainty of subjects regarding others’ rationality. We do so by comparing the price forecasts submitted by subjects in two market environments: (a) all six traders are human subjects (6H), and (b) one human subject interacts with five profit-maximizing computer traders who assume all the traders are also maximizing profit (1H5C). The subjects are told explicitly about the behavioral assumption of the computer traders (in both 6H and 1H5C) as well as which environment they are in. Results from our experiments show that there is no significant difference between the distributions of the initial deviations of the forecast prices from the fundamental values in the two markets. However, as subjects learn by observing the realized prices, the magnitude of deviations becomes significantly smaller in 1H5C than in 6H markets. We also conduct additional experiments where subjects who have experienced the 1H5C market interact with five inexperienced subjects. The price forecasts initially submitted by the experienced subjects follow the fundamental value despite the fact that the subjects are explicitly told that the five other traders in the market are inexperienced subjects. These findings do not support the hypothesis that uncertainty about others’ rationality plays a major role in causing substantial deviation of forecast prices from the fundamental values in these asset market experiments. |
| Keywords: | Rationality, Common knowledge, Experiment, Asset Markets, Computer Traders. |
| JEL: | C90 D84 |
| Date: | 2012–11–19 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1234&r=upt |