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on Utility Models and Prospect Theory |
| By: | Fabrice Collard (Department of Economics - University of Bern); Sujoy Mukerji (Department of Economics and University College - University of Oxford); Kevin Sheppard (Department of Economics and Oxford-Man Institute of Quantitative Finance - University of Oxford); Jean-Marc Tallon (Centre d'Economie de la Sorbonne - Paris School of Economics) |
| Abstract: | This paper assesses the quantitative impact of ambiguity on the historically observed financial asset returns and prices. The single agent, in a dynamic exchange economy, treats the conditional uncertainty about the consumption and dividends next period as ambiguous. We calibrate the agent's ambiguity aversion to match only the first moment of the risk-free rate in data and condition the uncertainty each period on the actual, observed history of (U.S.) macroeconomic growth outcomes. Ambiguity aversion accentuates the conditional uncertainty endogenously in a dynamic way, depending on the history; e.g., it increases during recessions. We show the model implied time series of asser returns match observed return dynamics of first and second conditional moments, very substantially. In particular, we find the time-series properties of our model generated equity premium, which may be regarded as an index measure of revealed uncertainty, relates very closely to those of the macroeconomic uncertainty index recently developed in Jurado, Ludvigson, and Ng (2013). |
| Keywords: | Ambiguity Aversion, Asset pricing, Equity premium puzzle, uncertainty shocks, time-varying uncertainty. |
| JEL: | G12 E21 D81 C63 |
| Date: | 2011–05 |
| URL: | http://d.repec.org/n?u=RePEc:mse:cesdoc:11032rr&r=upt |
| By: | Harris, Matthew; Kohn, Jennifer |
| Abstract: | We examine the effect of reference health on the demand for medical care. We propose and empirically implement a dynamic model of demand for medical care that includes reference health, an average of previous health states. We find that gain or loss from reference health significantly affects the demand for medical care. The effect is stronger for losses than gains. The effect is strongest in the upper tail of medical care consumers. We compare the predictions of our dynamic model with one that omits reference health. Including reference health improves our ability to match individuals in the top 5 percent by 65 percent. |
| Keywords: | Reference Dependence, Human Capital, Demand for Medical Care, Health Dynamics, Semi-Parametric, Conditional Density Estimation |
| JEL: | C14 I10 |
| Date: | 2015–02–05 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:61926&r=upt |
| By: | Kops, Christopher; Borah, Abhinash |
| Abstract: | We propose and axiomatically characterize a representation of ambiguity sensitive preferences. The distinguishing feature of our axiomatization is that we do not require preferences to be event-wise separable over any domain of acts. Even without any such separability restrictions, we are able to uniquely elicit the decision maker's subjective probabilities. The novel axiom that allows us to do so expresses the idea that at least in the domain of a certain class of acts the decision maker exhibits a consistent tradeoff between risk and ambiguity concerns. Under our representation of her preferences, any act is assessed by its subjective expected utility and a residual that captures her assessment of the act's exposure to ambiguity. |
| JEL: | D81 D00 D80 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:vfsc14:100629&r=upt |
| By: | Mazelis, Falk |
| Abstract: | This paper studies the role of uncertainty in the corporate cash hoarding puzzle. The baseline model is a stochastic neoclassical growth model featuring idiosyncratic and uninsurable technology shocks and a cash-in-advance constraint on new investments on the individual firm level. Individual agents' choices regarding cash holdings are analyzed and the effects of the introduction of a financial sector explored. The resulting aggregate cash holdings of households are non-optimal compared to the complete markets solution and aggregate excess cash increases with uncertainty. Aggregate consumption is also higher, but the added volatility of consumption decreases lifetime utility. Since cash holdings are usually managed by the financial sector, the results suggest a link between firm level risk and the behavior of the banking system. |
| JEL: | C63 E21 E41 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:vfsc14:100575&r=upt |
| By: | He, Yinghua |
| Abstract: | The Boston mechanism is criticized for its poor incentive and welfare performance compared with the Gale-Shapley deferred-acceptance mechanism (DA). Using school choice data from Beijing, I investigate parents' behavior under the Boston mechanism, taking into account parents' possible mistakes when they strategize. Evidence shows that parents are overcautious as they play "safe" strategies too often. There is no evidence showing that wealthier and more-educated parents are any more adept at strategizing. If others behave as in the data, an average naive parent who is always truth-telling experiences a utility loss in switching from the Boston to the DA, equivalent to an 8% increase in the distance from home to school or substituting a 13% chance at the best school with an equal chance at the second best. She has a 27% chance to be better off and a 55% chance being worse off. If instead parents are either sophisticated (always playing a best response against others) or naive, results are mixed: Under the DA, naive ones enjoy a utility gain on average when less than 80% of the population is naive, while still about 42% worse off and only 39% better off. Sophisticated parents always loose more. |
| Keywords: | Boston Mechanism, Gale-Shapley Deferred-Acceptance Mechanism, School Choice, Bayesian Nash Equilibrium, Strategy-Proofness, Moment Inequalities |
| JEL: | C72 D61 I24 |
| Date: | 2015–01 |
| URL: | http://d.repec.org/n?u=RePEc:tse:wpaper:28970&r=upt |
| By: | Patrick Beißner (Center for Mathematical Economics, Bielefeld University); Qian Lin (School of Economics and Management, Wuhan University) |
| Abstract: | We establish a class of fully nonlinear conditional expectations. Similarly to the usage of linear expectations when a probabilistic description of uncertainty is present, we observe analogue quantitative and qualitative properties. The type of nonlinearity captures the agents sentiments of optimism and pessimism in an ambiguous environment. We then introduce an expected utility under a nonlinear expectation, and show monotonicity and continuity of utility. Risk aversion is characterized, and the properties of the certainty equivalent are discussed. Finally, we derive an Arrow-Pratt approximation of the static certainty equivalent and investigate the dynamic version via recursive equations. |
| Keywords: | Nonlinear expectation, Knightian Uncertainty, time consistency, risk aversion, certainty equivalent, optimism and pessimism |
| JEL: | C60 D81 D90 |
| Date: | 2015–01 |
| URL: | http://d.repec.org/n?u=RePEc:bie:wpaper:535&r=upt |
| By: | Adam, Klaus (University of Mannheim); Marcet, Albert (Institute d'Analisi Economica); Nicolini, Juan Pablo (Federal Reserve Bank of Minneapolis) |
| Abstract: | Consumption-based asset pricing models with time-separable preferences can generate realistic amounts of stock price volatility if one allows for small deviations from rational expectations. We consider rational investors who entertain subjective prior beliefs about price behavior that are not equal but close to rational expectations. Optimal behavior then dictates that investors learn about price behavior from past price observations. We show that this imparts momentum and mean reversion into the equilibrium behavior of the price-dividend ratio, similar to what can be observed in the data. When estimating the model on U.S. stock price data using the method of simulated moments, we find that it can quantitatively account for the observed volatility of returns, the volatility and persistence of the price-dividend ratio, and the predictability of long-horizon returns. For reasonable degrees of risk aversion, the model generates up to one-half of the equity premium observed in the data. It also passes a formal statistical test for the overall goodness of fit, provided one excludes the equity premium from the set of moments to be matched. |
| Keywords: | Asset pricing; Learning; Subjective beliefs; Internal rationality |
| JEL: | E44 G12 |
| Date: | 2015–02–10 |
| URL: | http://d.repec.org/n?u=RePEc:fip:fedmwp:720&r=upt |
| By: | Cheung, Stephen L. |
| Abstract: | In both standard and behavioral theory, as well as experimental procedures to elicit time preference, it is commonly assumed that a single utility function is used to evaluate payoffs both under risk and over time. I introduce a novel experimental design to examine this assumption, by transposing the well-known Holt-Laury risk preference experiment from state-payoff space into time-dated payoff space. I find that the curvature of utility elicited directly from choices over time is significantly concave, but far closer to linear than utility elicited under risk. As a result, the effect of correcting discount rates for this curvature is modest. |
| Keywords: | Risk preference, time preference, measurement of utility, discounted utility, choice list. |
| Date: | 2015–01 |
| URL: | http://d.repec.org/n?u=RePEc:syd:wpaper:2015-01&r=upt |
| By: | Mecikovsky, Ariel Matias; Meier, Matthias |
| Abstract: | Using quarterly worker flow data of U.S. establishments, we find that an unexpected increase in uncertainty reduces hirings and quits, while it raises layoffs. This finding suggests that the real option effect of uncertainty is less important for employment decisions. Hence plants do not freeze in response to uncertainty shocks. To explain our findings, we propose a multi-worker plant search and matching model with decreasing returns to scale and financial frictions. As a result of unexpected uncertainty increase, plants reduce their employment size in order to decrease the default risk that arises from higher uncertainty in the economy. |
| JEL: | J23 J63 D81 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:vfsc14:100541&r=upt |
| By: | Farmer, Roger E A |
| Abstract: | This paper constructs a simple model in which asset price fluctuations are caused by sunspots. Most existing sunspot models use local linear approximations: instead, I construct global sunspot equilibria. My agents are expected utility maximizers with logarithmic utility functions, there are no fundamental shocks and markets are sequentially complete. Despite the simplicity of these assumptions, I am able to go a considerable way towards explaining features of asset pricing data that have presented an obstacle to previous models that adopted similar assumptions. My model generates volatile persistent swings in asset prices, a substantial term premium for long bonds and bursts of conditional volatility in rates of return. |
| Keywords: | asset prices; sunspots |
| JEL: | E44 G12 |
| Date: | 2015–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:10402&r=upt |
| By: | Vieider, Ferdinand; Villegas-Palacio, Clara; Martinsson, Peter; Mejía, Milagros |
| Abstract: | We examine situations in which a decision maker decides for another person as well as herself under conditions of payoff equality, and compare such decisions under responsibility to individual decisions. Estimating a structural model we find that responsibility leaves utility curvature unaffected, but accentuates the subjective distortion of very small and very large probabilities for both gains and losses. This results in an accentuation of prospect theory's four-fold pattern of risk preferences under responsibility. In addition, we also find that responsibility reduces loss aversion according to some common definitions of the latter. These results serve to reconcile some of the still largely contradictory findings in the literature on decisions for oneself and others under payoff equality. |
| Keywords: | risk preferences,responsibility,social preferences |
| JEL: | C93 D03 D80 O12 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:wzbrad:spii2015401&r=upt |
| By: | Bargain, Olivier; Jara Tamayo, Holguer Xavier |
| Abstract: | Subjective wellâ€being (SWB) is increasingly used as a way to measure individual wellâ€being. Interpreted as “experienced utilityâ€, it has been compared to “decision utility†using specific experiments (Kahneman et al., 1997) or stated preferences (Benjamin et al. 2012). We suggest here an original largeâ€scale comparison between ordinal preferences elicited from SWB data and those inferred from actual choices (revealed preferences). Precisely, we focus on incomeâ€leisure preferences, closely associated to redistributive policies. We compare indifference curves consistent with incomeâ€leisure subjective satisfaction with those derived from actual labor supply choices, on the same panel of British households. Results show striking similarities between these measures on average, reflecting that overall, people’s decision are not inconsistent with SWB maximization. Yet, the shape of individual preferences differ across approaches when looking at specific subpopulations. We investigate these differences and test for potential explanatory channels, particularly the roles of constraints and of individual “errors†related to aspirations, expectations or focusing illusion. We draw implications of our results for welfare analysis and policy evaluation. |
| Date: | 2015–02–09 |
| URL: | http://d.repec.org/n?u=RePEc:ese:iserwp:2015-02&r=upt |
| By: | Wilde, Christian; Krahnen, Jan Pieter; Ockenfels, Peter |
| Abstract: | This paper provides a systematic analysis of individual attitudes towards ambiguity, based on laboratory experiments. The design of the analysis allows to capture individual behavior across various levels of ambiguity, ranging from low to high. Attitudes towards risk and attitudes towards ambiguity are disentangled, providing pure measures of ambiguity aversion. Ambiguity aversion is captured in several ways, i.e. as a discount factor net of a risk premium, and as an estimated parameter in a generalized utility function. We find that ambiguity aversion varies across individuals, and with the level of ambiguity, being most prominent for intermediate levels. Around one third of subjects show no aversion, one third show maximum aversion, and one third show intermediate levels of ambiguity aversion, while there is almost no ambiguity seeking. While most theoretical work on ambiguity builds on maxmin expected utility, our results provide evidence that MEU does not adequately capture individual attitudes towards ambiguity for the majority of individuals. Instead, our results support models that allow for intermediate levels of ambiguity aversion. Moreover, we find risk aversion to be statistically unrelated to ambiguity aversion on average. Taken together, the results support the view that ambiguity is an important and distinct argument in decision making under uncertainty. |
| JEL: | D81 C91 D03 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:vfsc14:100557&r=upt |
| By: | Dicks, David L; Fulghieri, Paolo |
| Abstract: | We present a novel source of disagreement grounded in decision theory: ambiguity aversion. We show that ambiguity aversion generates endogenous disagreement between a firm's insider and outside shareholders, creating a new rationale for corporate governance systems. In our paper, optimal corporate governance depends on both firm characteristics and the composition of the outsiders' overall portfolio. A strong governance system is desirable when the value of the firm's assets in place, relative to the growth opportunity, is sufficiently small or is sufficiently large, suggesting a corporate governance life cycle. In addition, more diversified outsiders (such as generalist mutual funds) prefer stronger governance, while outsiders with a portfolio heavily invested in the same asset class as the firm (such as venture capitalists or private equity investors) are more willing to tolerate a weak governance system, where the portfolio companies' insiders have more leeway in determining corporate policies. Finally, we find that ambiguity aversion introduces a direct link between the strength of the corporate governance system and firm transparency, whereby firms with weaker governance should also optimally be more opaque. |
| Keywords: | ambiguity aversion; corporate governance; disagreement |
| JEL: | G30 |
| Date: | 2015–02 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:10400&r=upt |
| By: | Brandtner, Mario; Kürsten, Wolfgang |
| Abstract: | We analyze spectral risk measures with respect to comparative risk aversion following Arrow (1965) and Pratt (1964) on the one hand, and Ross (1981) on the other hand. The implications for two standard financial decision problems, namely the willingness to pay for insurance and portfolio selection, are studied. Within the framework of Arrow and Pratt, we show that the widely-applied spectral Arrow-Pratt-measure is not a consistent measure of Arrow-Pratt-risk aversion. A decision maker with a greater spectral Arrow-Pratt-measure may only be willing to pay less for insurance or to invest more in the risky asset than a decision maker with a smaller spectral Arrow-Pratt-measure. We further show how a proper measure of Arrow-Pratt-risk aversion should look like instead. Within the framework of Ross, we show that the popular subclasses of Conditional Value-at-Risk, and exponential and power spectral risk measures cannot be completely ordered with respect to Ross-risk aversion. As a consequence, these subclasses also exhibit counter-intuitive comparative static results. In the insurance problem, the willingness to pay for insurance may be decreasing with increasing risk parameter. In the portfolio selection problem, the investment in the risky asset may be increasing with increasing risk parameter. These shortcomings have to be considered before spectral risk measures can be applied for the purpose of optimal decision making and regulatory issues. |
| JEL: | D81 G11 G21 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:vfsc14:100615&r=upt |
| By: | Ott, Marion; Ehrhart, Karl-Martin |
| Abstract: | We investigate equilibrium bidding behavior of bidders with reference-dependent preferences and independent private values in single-unit English and Dutch clock auctions. Bidders' reference points are endogenous and determined by their strategy and their beliefs about the other bidders. In deriving their strategy, bidders anticipate changes in their reference point due to updated information about others' values (i.e., the own winning probability) during the course of the auction, and make optimal binary decisions at each price (approve or quit in the English auction and wait or bid in the Dutch auction). First, we solve for personal equilibrium profiles, i.e., profiles of bids that contain for each bidder a bidding strategy that is optimal given the others' bidding strategies and the reference point induced by the own and others' strategies. Second, we consider locally preferred personal equilibrium (LPPE) profiles, i.e., personal equilibrium profiles where no bidder can locally find a better personal equilibrium given the others' fixed strategies by varying his reference point via considering different own strategies. The expected revenue in the Dutch auction is higher than in the English auction in the respective unique LPPE profiles. The difference is mainly driven by the aversion to losing the item in the Dutch auction. |
| JEL: | D44 D03 C72 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:vfsc14:100591&r=upt |
| By: | Abel , Martin; Cole, Shawn; Zia, Bilal |
| Abstract: | This paper tests experiential learning as a debiasing tool against gambling and lottery behavior in South Africa. The study implemented a simple, interactive dice game that simulates worsening winning odds of rolling sixes as more dice are added to the game. The analysis exploits two levels of exogenous variation, first from random assignment into the debiasing game, and second from the number of rolls it takes to obtain the sixes. Treated individuals who needed above-median number of rolls to obtain simultaneous sixes are significantly less likely than the control group to gamble or play the lottery in the following year. The converse is true for individuals who needed below-median number of rolls, suggesting a perverse treatment effect among this group. The analysis also finds suggestive evidence that the debiasing affected the sensitivity to varying winning odds. Changes in entertainment utility or risk preferences cannot explain these findings, rather the results are consistent with changes in risk beliefs. |
| Keywords: | Financial Literacy,Educational Sciences,Knowledge for Development,Access&Equity in Basic Education,Economic Theory&Research |
| Date: | 2015–02–01 |
| URL: | http://d.repec.org/n?u=RePEc:wbk:wbrwps:7195&r=upt |
| By: | Schröder, David; Cavatorta, Elisa |
| Abstract: | Ambiguity aversion has shown to be economically relevant and has been proposed as an explanation for many phenomena in economics and fi nance. While the literature has suggested a large variety of elicitation methods to measure ambiguity preferences, their consistency and reliability it is rarely evaluated. This is the fi rst study that systematically analyses the consistency of individual ambiguity preferences elicited using a variety of incentivized tasks, non-incentivized thought experiments and survey questions. We fi nd a high degree of aggregate consistency across elicitation methods, but large discrepancies in degrees of individual consistency in pair-wise tasks comparisons. Finally, the study identi es a set of non-incentivized tasks that predict ambiguity attitudes elicited experimentally which may serve as a viable alternative when running laboratory experiments is unfeasible. |
| JEL: | C91 C81 D01 |
| Date: | 2014 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:vfsc14:100593&r=upt |