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on Utility Models and Prospect Theory |
| By: | Carole Bernard; Jit Seng Chen; Steven Vanduffel |
| Abstract: | Assuming that agents' preferences satisfy first-order stochastic dominance, we show that the Expected Utility Paradigm can explain all rational investment choices. In particular, the optimal investment strategy in any behavioral law-invariant setting corresponds to the optimum for some risk averse expected utility maximizer whose concave utility function we derive explicitly. This result enables us to infer agents' utility and risk aversion from their investment choice in a non-parametric way. We also show that decreasing absolute risk aversion (DARA) is equivalent to a demand for terminal wealth that has more spread than the opposite of the log pricing kernel at the investment horizon. |
| Date: | 2013–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1302.4679&r=upt |
| By: | Eric André (Aix-Marseille University (Aix-Marseille School of Economics, EHESS & CNRS.) |
| Abstract: | We study the optimal portfolio selected by an investor who conforms to Siniscalchi (2009)’s Vector Expected Utility’s (VEU) axioms and who is ambiguity averse. To this end, we derive a mean-variance preference generalised to ambiguity from the second-order Taylor-Young expansion of the VEU certainty equivalent. We apply this Mean Variance Variability preference to the static two-assets portfolio problem and deduce asset allocation results which extend the mean-variance analysis to ambiguity in the VEU framework. Our criterion has attractive features: it is axiomatically well-founded and analytically tractable, it is therefore well suited for applications to asset pricing as proved by a novel analysis of the home-bias puzzle with two ambiguous assets. |
| Keywords: | Vector Expected Utility, Ambiguity, Portfolio Choice, Home-bias Puzzle. |
| JEL: | D81 G11 |
| Date: | 2013–02–11 |
| URL: | http://d.repec.org/n?u=RePEc:aim:wpaimx:1308&r=upt |
| By: | Eric Danan (THEMA - THéorie Economique, Modélisation et Applications - université de Cergy-Pontoise); Thibault Gajdos (GREQAM - Groupement de Recherche en Économie Quantitative d'Aix-Marseille - Université de la Méditerranée - Aix-Marseille II - Université Paul Cézanne - Aix-Marseille III - Ecole des Hautes Etudes en Sciences Sociales (EHESS) - CNRS : UMR7316); Jean-Marc Tallon (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) |
| Abstract: | We analyze the aggregation problem without the assumption that individuals and society have fully determined and observable preferences. More precisely, we endow individuals ans society with sets of possible von Neumann-Morgenstern utility functions over lotteries. We generalize the classical neutrality assumption to this setting and characterize the class of neutral social welfare function. This class turns out to be considerably broader for indeterminate than for determinate utilities, where it basically reduces to utilitarianism. In particular, aggregation rules may differ by the relationship between individual and social indeterminacy. We characterize several subclasses of neutral aggregation rules and show that utilitarian rules are those that yield the least indeterminate social utilities, although they still fail to systematically yield a determinate social utility. |
| Keywords: | Aggregation - vNM utility - indeterminacy - neutrality - utilitarianism |
| Date: | 2013 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00788647&r=upt |
| By: | Bent Flyvbjerg |
| Abstract: | A major source of risk in project management is inaccurate forecasts of project costs, demand, and other impacts. The paper presents a promising new approach to mitigating such risk, based on theories of decision making under uncertainty which won the 2002 Nobel prize in economics. First, the paper documents inaccuracy and risk in project management. Second, it explains inaccuracy in terms of optimism bias and strategic misrepresentation. Third, the theoretical basis is presented for a promising new method called "reference class forecasting," which achieves accuracy by basing forecasts on actual performance in a reference class of comparable projects and thereby bypassing both optimism bias and strategic misrepresentation. Fourth, the paper presents the first instance of practical reference class forecasting, which concerns cost forecasts for large transportation infrastructure projects. Finally, potentials for and barriers to reference class forecasting are assessed. |
| Date: | 2013–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1302.3642&r=upt |
| By: | Nina Boyarchenko; Mario Cerrato; John Crosby; Stewart Hodges |
| Abstract: | Faced with the problem of pricing complex contingent claims, an investor seeks to make his valuations robust to model uncertainty. We construct a notion of a model- uncertainty-induced utility function and show that model uncertainty increases the investor's effective risk aversion. Using the model-uncertainty-induced utility function, we extend the "No Good Deals" methodology of Cochrane and Saa-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: | Asset pricing theory; Good deal bounds; Knightian uncertainty; Model uncertainty; Contingent claim pricing. model-uncertainty-induced utility function |
| JEL: | G12 G13 |
| Date: | 2013–01 |
| URL: | http://d.repec.org/n?u=RePEc:gla:glaewp:2013_04&r=upt |
| By: | Florent Buisson (CES - Centre d'économie de la Sorbonne - CNRS : UMR8174 - Université Paris I - Panthéon-Sorbonne) |
| Abstract: | In an often quoted article, Genesove and Mayer (2001) observe that house sellers are reluctant to sell at a loss, and attribute this finding to loss aversion. I show that loss aversion cannot explain this phenomenon. |
| Keywords: | Loss aversion; prospect theory; housing market |
| Date: | 2013–01 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-00786294&r=upt |
| By: | Paolo Crosetto (Max Planck Institute for Economics, Jena); Antonio Filippin (University of Milan, Department of Economics, and Institute for the Study of Labor (IZA)) |
| Abstract: | We perform a comparative analysis of five incentivized tasks used to elicit risk preferences. Theoretically, we compare the elicitation methods in terms of completeness of the range of the estimates as well as their precision, the likelihood of triggering loss aversion, and problems arising when multiple choices are required. Using original data from a homogeneous population, we experimentally investigate the distribution of estimated risk preferences, whether they differ by gender, and the complexity of the tasks. We do so using both non-parametric tests and a structural model estimated with maximum likelihood. We find that the estimated risk aversion parameters vary greatly across tasks and that gender differences appear only when the task is more likely to trigger loss aversion. |
| Keywords: | Risk attitudes, Elicitation methods, Experiment |
| JEL: | C81 C91 D81 |
| Date: | 2013–02–19 |
| URL: | http://d.repec.org/n?u=RePEc:jrp:jrpwrp:2013-009&r=upt |
| By: | Turan G. Bali (McDonough School of Business, Georgetown University); Hao Zhou (Division of Research and Statistics, Federal Reserve Board) |
| Abstract: | A conditional asset pricing model with risk and uncertainty implies that the time-varying exposures of equity portfolios to the market and uncertainty factors carry positive risk premiums. The empirical results from the size, book-to-market, and industry portfolios as well as individual stocks indicate that the conditional covariances of equity portfolios (individual stocks) with market and uncertainty predict the time-series and cross-sectional variation in stock returns. We find that equity portfolios that are highly correlated with economic uncertainty proxied by the variance risk premium (VRP) carry a significant, annualized 6 to 8 percent premium relative to portfolios that are minimally correlated with VRP. |
| Keywords: | Risk, Uncertainty, Expected Returns, ICAPM, Time-Series and Cross-Sectional Stock Returns, Variance Risk Premium, Conditional Asset Pricing Model. |
| JEL: | G10 G11 C13 |
| Date: | 2013–02 |
| URL: | http://d.repec.org/n?u=RePEc:koc:wpaper:1306&r=upt |
| By: | Claudio Fontana; Bernt {\O}ksendal; Agn\`es Sulem |
| Abstract: | We consider a financial market model with a single risky asset whose price process evolves according to a general jump-diffusion with locally bounded coefficients and where market participants have only access to a partial information flow $(\E_t)_{t\geq0}\subseteq(\F_t)_{t\geq0}$. For any utility function, we prove that the partial information financial market is locally viable, in the sense that the problem of maximizing the expected utility of terminal wealth has a solution up to a stopping time, if and only if the marginal utility of the terminal wealth is the density of a partial information equivalent martingale measure (PIEMM). This equivalence result is proved in a constructive way by relying on maximum principles for stochastic control under partial information. We then show that the financial market is globally viable if and only if there exists a partial information local martingale deflator (PILMD), which can be explicitly constructed. In the case of bounded coefficients, the latter turns out to be the density process of a global PIEMM. We illustrate our results by means of an explicit example. |
| Date: | 2013–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1302.4254&r=upt |
| By: | Ronald Stauber |
| Abstract: | This paper defines simple procedures to construct ambiguous perturbations of belief structures associated to standard type spaces with precise beliefs, based on ambiguous type spaces whose induced belief hierarchies approximate the belief hierarchies corresponding to the initial type space. Two alternative procedures to construct such perturbations are introduced, and are shown to yield a simple and intuitive characterization of convergence of the resulting approximations to the initial unperturbed environment. The perturbations arising from one of these procedures include the set of all finite perturbations as a special case. The introduced perturbations and their convergence properties provide a foundation for the analysis of robustness to ambiguity of various solutions concepts, and for various decision rules under ambiguity. |
| JEL: | C72 D83 |
| Date: | 2013–02 |
| URL: | http://d.repec.org/n?u=RePEc:acb:cbeeco:2013-602&r=upt |