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on Utility Models and Prospect Theory |
| By: | Gaurab Aryal; Ronald Stauber |
| Abstract: | Kuhn's Theorem shows that extensive games with perfect recall can equivalently be analyzed using mixed or behavioral strategies, as long as players are expected utility maximizers. This note constructs an example that illustrate the limits of Kuhn's Theorem in an environment with ambiguity averse players who use maxmin decision rule and full Bayesian updating. |
| Date: | 2014–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1408.1022&r=upt |
| By: | Paul Viefers; Philipp Strack |
| Abstract: | Many economic situations involve the timing of irreversible decisions. E.g. People decide when to sell a stock or stop searching for a better price. We analyze the behavior of a decision maker who evaluates his choice relative to the ex-post optimal choice in an optimal stopping task. We derive the optimal strategy under such regret preferences, and show how it is different from that of an expected utility maximizer. We also show that if the decision maker never commits mistakes the behavior resulting from this strategy is observationally equivalent to that of an expected utility maximizer. We then test our theoretical predictions in the laboratory. The results from a structural discrete choice model we fit to our data provide strong evidence that many people's stopping behavior is largely determined by the anticipation of and aversion to regret. |
| Keywords: | Optimal stopping, Dynamic behavior, Regret |
| JEL: | D3 C91 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:diw:diwwpp:dp1401&r=upt |
| By: | Peter Bank; Helena Kauppila |
| Abstract: | We develop a general theory of convex duality for certain singular control problems, taking the abstract results by Kramkov and Schachermayer (1999) for optimal expected utility from nonnegative random variables to the level of optimal expected utility from increasing, adapted controls. The main contributions are the formulation of a suitable duality framework, the identification of the problem's dual functional as well as the full duality for the primal and dual value functions and their optimizers. The scope of our results is illustrated by an irreversible investment problem and the Hindy-Huang-Kreps utility maximization problem for incomplete financial markets. |
| Date: | 2014–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1407.7717&r=upt |
| By: | Giorgia Callegaro; Luciano Campi; Tiziano Vargiolu |
| Abstract: | In this paper we focus on pricing of structured products in energy markets using utility indifference pricing approach. In particular, we compute the buyer's price of such derivatives for an agent investing in the forward market, whose preferences are described by an exponential utility function. Such a price is characterized in terms of continuous viscosity solutions of suitable non-linear PDEs. This provides an effective way to compute both an optimal exercise strategy for the structured product and a portfolio strategy to partially hedge the financial position. In the complete market case, the financial hedge turns out to be perfect and the PDE reduces to particular cases already treated in the literature. Moreover, in a model with two assets and constant correlation, we obtain a representation of the price as the value function of an auxiliary simpler optimization problem under a risk neutral probability, that can be viewed as a perturbation of the minimal entropy martingale measure. Finally, numerical results are provided. |
| Date: | 2014–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1407.7725&r=upt |
| By: | Sheremeta, Roman |
| Abstract: | The standard theoretical description of rent-seeking contests is that of rational individuals or groups engaging in socially inefficient behavior by exerting costly effort. Experimental studies find that the actual efforts of participants are significantly higher than predicted in the models based on rational behavior and that over-dissipation of rents (or overbidding or over-expenditure of resources) can occur. Although over-dissipation cannot be explained by the standard rational-behavior theory, it can be explained by incorporating behavioral dimensions into the standard model, such as (1) the utility of winning, (2) relative payoff maximization, (3) bounded rationality, and (4) judgmental biases. These explanations are not exhaustive but provide a coherent picture of important behavioral dimensions to be considered when studying rent-seeking behavior in theory and in practice. |
| Keywords: | rent-seeking, contests, experiments, overbidding, over-dissipation |
| JEL: | C72 C91 C92 D72 D74 |
| Date: | 2014–08–04 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:57751&r=upt |
| By: | Paresh Kumar Narayan (Deakin University); Huson Ali Ahmed (Deakin University) |
| Abstract: | In this paper our goal is to examine the importance of skewness in decision making, in particular on investor utility. We use time-series daily data on sectoral stock returns on the Indian stock exchange. We test for sectoral stock return predictability using commonly used financial ratios, namely, the book-to-market, dividend yield and price-earnings ratio. We find strong evidence of predictability. Using this evidence of predictability, we forecast sectoral stock returns for each of the sectors in our sample, allowing us to devise trading strategies that account for skewness of returns. We discover evidence that accounting for skewness leads not only to higher utility compared to a model that ignores skewness, but utility is sector-dependent. |
| Keywords: | Returns; Skewness; Predictability; Utility; Investor. |
| Date: | 2014–07–07 |
| URL: | http://d.repec.org/n?u=RePEc:dkn:ecomet:fe_2014_11&r=upt |
| By: | Mike Moses (Beautiful Asset Advisors, LLC); Rachel Pownall (Maastricht University and Tilberg University) |
| Abstract: | We find evidence for the behavioral biases of anchoring and loss aversion. We find that anchoring is more important for items that are resold quickly, and we find that the effect of loss aversion increases with the time that a painting is held. The evidence in favor of anchoring and loss aversion with this large dataset validates previous results and adds to the empirical evidence a finding of increasing loss aversion with the length a painting is held. We do not find evidence that investors can take advantage of these behavioral biases. |
| Keywords: | anchoring, loss aversion, endowment effect, art auctions |
| JEL: | D03 D44 Z11 |
| Date: | 2014–06 |
| URL: | http://d.repec.org/n?u=RePEc:brd:wpaper:73&r=upt |
| By: | Xiang Yu |
| Abstract: | This paper studies the utility maximization problem on consumption with addictive habit formation in the markets with proportional transaction costs and unbounded random endowment. To model the proportional transaction costs, we adopt Kabanov's multi-asset framework with a cash account. At the terminal time $t=T$, the investor can receive an unbounded random endowment for which we propose a new definition of acceptable portfolio processes depending on the strictly consistent price system (SCPS). We prove a type of super-hedging theorem for a family of workable contingent claims using the acceptable portfolios and random endowment which enables us to obtain the consumption budget constraint result under the market frictions. With the path dependence reduction and the embedding approach, the existence and uniqueness of the optimal consumption are proved using the auxiliary primal and dual processes and the convex duality analysis. |
| Date: | 2014–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1408.1382&r=upt |
| By: | Max Löffler; Andreas Peichl; Sebastian Siegloch |
| Abstract: | There is still considerable dispute about the magnitude of labor supply elasticities. While differences in micro and macro estimates are recently attributed to frictions and adjustment costs, we show that relatively low labor supply elasticities derived from microeconometric models can also be explained by modeling assumptions with respect to wages. Specifically, we estimate 3,456 structural labor supply models each representing a plausible combination of frequently made choices. While most model assumptions do not systematically affect labor supply elasticities, our analysis shows that the results are very sensitive to the treatment of wages. In particular, the often-made but highly restrictive independence assumption between preferences and wages is key. To overcome this restriction, we propose a flexible estimation strategy that nests commonly used models. We show that loosening the exogeneity assumption leads to labor supply elasticities that are much higher. |
| Keywords: | labor supply, elasticity, random utility models, wages |
| JEL: | C25 C52 H31 J22 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:diw:diwsop:diw_sp675&r=upt |
| By: | Patrizia Ordine; Giuseppe Rose (Dipartimento di Economia, Statistica e Finanza, Università della Calabria) |
| Abstract: | State- and Wealth-dependence of individual risk preferences are investigated using Italian panel data. To elicit risk aversion, a social security policy reform occurred in Italy in 2008 is exploited. This law asks private sector employees to invest their accruing severance pay in three alternative pension funds strongly heterogeneous in terms of risk. The determinants of this choice are analyzed and the focus is posed on the effect of wealth and job-status. These are investigated considering i) the behavior of workers changing job contract; ii) the presence of different income prospects associated to labor contracts'?length; iii) the exogenous threshold provided by fi?rm size in terms of Employment Protection Legislation. Fixed-Effects estimates show that preferred funds - and consequently risk preferences - are not affected by wealth modi?cations pointing out for the presence of Constant Relative Risk Aversion. Conversely, job contract characteristics in terms of job protection from the risk of layoff appear to signifi?cantly affect risk attitude pointing for the existence of a State Dependent Constant Relative Risk Aversion. |
| Keywords: | Relative Risk Aversion, Pension Funds, Panel Data, Job Movers |
| JEL: | D10 D80 D81 |
| Date: | 2014–07 |
| URL: | http://d.repec.org/n?u=RePEc:clb:wpaper:201407&r=upt |
| By: | Eric J. Allen; Patricia M. Dechow; Devin G. Pope; George Wu |
| Abstract: | Models of reference-dependent preferences propose that individuals evaluate outcomes as gains or losses relative to a neutral reference point. We test for reference dependence in a large dataset of marathon finishing times (n = 9,524,071). Models of reference-dependent preferences such as prospect theory predict bunching of finishing times at reference points. We provide visual and statistical evidence that round numbers (e.g., a four-hour marathon) serve as reference points in this environment and as a result produce significant bunching of performance at these round numbers. Bunching is driven by planning and adjustments in effort provision near the finish line and cannot be explained by explicit rewards (e.g., qualifying for the Boston Marathon), peer effects, or institutional features (e.g., pacesetters). We calibrate a simple model of prospect theory as well as other models of reference dependence and show that the basic qualitative shape of the empirical distribution of finishing times is consistent with parameters that have previously been estimated in the laboratory. |
| JEL: | D03 J22 |
| Date: | 2014–07 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:20343&r=upt |
| By: | Yuhong Xu |
| Abstract: | Model uncertainty is a type of inevitable financial risk. Mistakes on the choice of pricing model may cause great financial losses. In this paper we investigate financial markets with mean-volatility uncertainty. Models for stock markets and option markets with uncertain prior distribution are established by Peng's G-stochastic calculus. The process of stock price is described by generalized geometric G-Brownian motion in which the mean uncertainty may move together with or regardless of the volatility uncertainty. On the hedging market, the upper price of an (exotic) option is derived following the Black-Scholes-Barenblatt equation. It is interesting that the corresponding Barenblatt equation does not depend on the risk preference of investors and the mean-uncertainty of underlying stocks. Hence under some appropriate sublinear expectation, neither the risk preference of investors nor the mean-uncertainty of underlying stocks pose effects on our super and subhedging strategies. Appropriate definitions of arbitrage for super and sub-hedging strategies are presented such that the super and sub-hedging prices are reasonable. Especially the condition of arbitrage for sub-hedging strategy fills the gap of the theory of arbitrage under model uncertainty. Finally we show that the term $K$ of finite-variance arising in the super-hedging strategy is interpreted as the max Profit\&Loss of being short a delta-hedged option. The ask-bid spread is in fact the accumulation of summation of the superhedging $P\&L$ and the subhedging $P\&L $. |
| Date: | 2014–07 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1407.8024&r=upt |
| By: | Zaifu Yang; Rong Zhang |
| Abstract: | We develop a new model of addictive behavior that takes as a starting point the classic rational addiction model of Becker and Murphy, but incorporates uncertainty. We model uncertainty through the Wiener stochastic process. This process captures both random events such as anxiety, tensions and environmental cues which can precipitate and exacerbate addictions, and those sober and thought-provoking episodes that discourage addictions. We derive closed-form expressions for optimal (and expected optimal) addictive consumption and capital trajectories and examine their global and local properties. Our theory provides plausible explanations of several important patterns of addictive behavior, and has novel implications for addiction control policy. |
| Keywords: | Rational Addiction; Stochastic Control; Uncertainty |
| JEL: | C61 D01 D11 I10 I18 K32 |
| Date: | 2014–07 |
| URL: | http://d.repec.org/n?u=RePEc:yor:yorken:14/12&r=upt |
| By: | Pereira Reichhardt, Joaquín; Iqbal, Tabassum |
| Abstract: | The purpose of this paper is to understand the reasons behind financial market behavior that often does not match that proposed by classic finance models. In particular, this work tests the fully-rational agents assumption made by classic finance to explain investment decisions under uncertainty. Many issues claim for a better alternative explanation to classic finance, regarding how and why of the financial market behavior changes. Among these issues, we may highlight: housing bubbles, financial crisis, excess of volatility, high heterogeneity in analyst forecasts, and a large amount of speculators looking for the “holy grail” to profit from the market. In order to answer the question, this paper has selected the most salient financial market anomalies, such as, the Closed-end fund mispricing and the Excess Volatility in stock markets. The purpose is to test by a thorough review of empirical works existent in the literature the assumption of fully-rationality in investment decisions. Subsequently, it goes deeper into trying to understand the way people – and investors – make decisions under uncertainty. A relevant and very popular bias is Overconfidence which is deeply analyzed, as well as the highly observed tendency among traders to let losing positions run while cutting winners too early (the Disposition Effect). For the latter, this study provides support on the theory of prospects and the Mental Accounting bias. Finally, the research focuses on unconscious mental strategies that people use to evaluate the likelihood of events, as well as the value of assets in a quick and low-cost way: Availability and Anchoring heuristics. The main findings of this research are that a) Markets are not efficient always; b) People are quasi-rational; hence the assumption of full-rationality is not realistic to interpret and forecast financial markets; and c) There is a deep ocean of cognitive factors in every individual and most of the time those are present in financial decision making, thus affecting the optimal output of their estimations and solutions to problems under uncertainty. |
| Keywords: | Behavioral finance, market anomalies, loss aversion, heuristics, biases |
| JEL: | G11 G12 G15 |
| Date: | 2014–07–30 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:57686&r=upt |