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on Utility Models and Prospect Theory |
| By: | Rui Pedro Brito (Faculty of Economics, University of Coimbra, and GEMF, Portugal); Hélder Sebastião (Faculty of Economics, University of Coimbra, and GEMF, Portugal); Pedro Godinho (Faculty of Economics, University of Coimbra, and GEMF, Portugal) |
| Abstract: | In this paper we extend the study of the cardinality impact from the standard mean-variance scenario to higher moments, considering a utility maximization framework. For each scenario, we propose a bi-objective model that allows the investor to directly analyse the efficient trade-off between expected utility and cardinality. We study not only the effect of cardinality in each scenario but also the real gain of considering higher moments in portfolio management. This analysis is performed assuming that the investor has constant relative risk aversion (CRRA) preferences. For the data collected on the PSI20 index, the empirical results showed that there are no performance gains, in-sample, from the efficient mean-variance expected utility/cardinality portfolios to the efficient expected utility/cardinality portfolios when higher moments are considered. However, the out-of-sample performance of the efficient mean-variance-skewness expected utility/cardinality portfolios and of the efficient mean-variance-skewness-kurtosis expected utility/cardinality portfolios suggest the existence of real gains, especially when transaction costs are considered. |
| Keywords: | Portfolio management, cardinality, expected utility maximization, CRRA preferences, derivative-free optimization, PSI20 index. |
| JEL: | C44 C58 C61 C63 C88 G11 |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:gmf:wpaper:2015-15.&r=upt |
| By: | Frantisek Kopriva |
| Abstract: | I analyze the risk preferences of bettors using data from the world's largest betting exchange, Betfair. The assumption of a constant bet size, commonly used in the current literature, leads to an unrealistic model of bettors' decision making as a choice between a high return - low variance and low return - high variance bet, automatically implying risk-loving preferences of bettors. However, the data show that bettors bet different amounts on different odds. Thus, simply by introducing the computed average bet size at given odds I transform the bettor's decision problem into a standard choice between low return - low variance and high return - high variance bets, and I am able to correctly estimate the risk attitudes of bettors. Results indicate that bettors on Betfair are either risk neutral (tennis and soccer markets) or slightly risk loving (horse racing market). I further use the information on the average bet size to test the validity of Expected utility theory (EUT). The results suggest that, when facing a number of outcomes with different winning probabilities, bettors tend to overweight small and underweight large differences in probabilities, which is in direct contradiction to the linear probability weighting function implied by EUT. |
| Keywords: | decision making under risk; expected utility theory; betting exchanges; |
| JEL: | D01 D03 D81 |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:cer:papers:wp545&r=upt |
| By: | Irene Comeig (ERICES and University of Valencia); Charles A. Holt (University of Virginia); Ainhoa Jaramillo-Gutiérrez (ERICES and Jaume I University, Castellón) |
| Abstract: | This paper investigates how subjects deal with financial risk, both "upside" (with a small chance of a high payoff) and "downside" (with a small chance of a low payoff). We find that the same people who avoid risk in the downside setting tend to make more risky choices in the upside one. The experiment is designed to disentangle the probability-weighting and utility-curvature components of risk attitudes, and to differentiate settings in which gender differences arise from those in which they do not. Women are more risk averse for downside risks, but gender differences are diminished for upside risks. |
| Keywords: | risk aversion, probability weighting, rank-dependent utility, gender differences, experiments |
| JEL: | C91 G02 |
| Date: | 2015–03 |
| URL: | http://d.repec.org/n?u=RePEc:dbe:wpaper:0215&r=upt |
| By: | Matthew Gentry (Institute for Fiscal Studies and London School of Economics); Tong Li (Institute for Fiscal Studies and Vanderbilt University); Jingfeng Lu (Institute for Fiscal Studies) |
| Abstract: | We study identification and estimation in first-price auctions with risk-averse bidders and selective entry, building on a flexible entry and bidding framework we call the Affiliated Signal with Risk Aversion (AS- RA) model. This framework extends the AS model of Gentry and Li (2014) to accommodate arbitrary bidder risk aversion, thereby nesting a variety of standard models as special cases. It poses, however, a unique methodological challenge - existing results on identification with risk aversion fail in the presence of selection, while the selection-robust bounds of Gentry and Li (2014) fail in the presence of risk aversion. Motivated by this problem, we translate excludable variation in potential competition into identified sets for AS-RA primitives under various classes of restrictions on the model. We show that a single parametric restriction - on the copula governing selection into entry - is typically sufficient to restore point identification of all primitives. In contrast, a parametric form for utility yields point identification of the utility function but only partial identification of remaining primitives. Finally, we outline a simple semiparametric estimator combining Constant Relative Risk Aversion utility with a parametric signal-value copula. Simulation evidence suggests that this estimator performs very well even in small samples, underscoring the practical value of our identification results. |
| Keywords: | Auctions; endogenous participation; risk aversion; identification |
| Date: | 2015–04 |
| URL: | http://d.repec.org/n?u=RePEc:ifs:cemmap:16/15&r=upt |
| By: | John Quah; Hiroki Nishimura; Efe A. Ok |
| Abstract: | Richter's theorem and Afriat's theorem are two fundamental results underlying modern revealed preference analysis. In this paper, we provide a version of Richter's theorem that characterizes the rationalizability of a choice data set with a continuous utility function (rather than simply a complete preorder as in the original result) and extend Afriat's theorem so it becomes applicable in choice environments other than the classical setting of consumer demand. Furthermore, while standard treatments give very different proofs for these two results, we introduce a framework within which both results can be formulated and established in tandem. We also demonstrate how our generalized versions of these theorems can be used in empirical studies. In particular, we apply our results to devise tests for rationalizability in the context of choice data over lotteries, contingent consumption, intertemporal consumption, and positions in policy space. Some new results on the revealed preference theory of consumer demand (for instance, on the possibility of deriving utility functions from estimated Engel curves) are also reported. |
| Keywords: | Revealed Preference, Rational Choice, Afriat's Theorem, Richter's Theorem, Engel Curves. |
| JEL: | D11 D81 |
| Date: | 2015–07–15 |
| URL: | http://d.repec.org/n?u=RePEc:oxf:wpaper:752&r=upt |
| By: | Stan Palasek |
| Abstract: | Debreu's classic theorem asserts that when an agent's weak preference ordering is reflexive, transitive, and closed in a suitable topology, it can be represented by a continuous utility function. Of interest in some economic settings is to weaken these conditions by replacing transitivity with negative transitivity. Such preferences have been successfully modeled using multi-utility representations, ie. an order embedding into $\mathbb{R}^n$ rather than simply $\mathbb{R}$. Here we show that the topological conditions for a continuous single utility representation are sufficient to guarantee a continuous multi-utility representation, closing a conjecture of Nishimura & Ok (2015). The impossibility of a multi-utility representation consistent with Pareto improvement is also demonstrated. |
| Date: | 2015–08 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1508.00607&r=upt |
| By: | Pavlo Blavatskyy (School of Management and Governance, Murdoch University); Andreas Ortmann (School of Economics, UNSW Business School, UNSW); Valentyn Panchenko (School of Economics, UNSW Business School, UNSW) |
| Abstract: | The Allais Paradox, or Common Consequence Effect to be precise, is one of the most wellknown behavioral regularities in individual decision making under risk. A common perception in the literature, which motivated the development of numerous generalized non‐expected utility theories, is that the Allais Paradox is a robust empirical finding. We argue that such a perception does not accurately reflect the experimental evidence on the Allais Paradox and show how specific choices of parameters can make it appear, disappear, or reverse. For example, our results suggest that the Allais Paradox is likely to disappear when lotteries involve relatively small outcomes under real financial incentives and probability distributions are described as compound lotteries or in a frequency format (rather than as reduced‐form simple lotteries). We also find that the Allais Paradox is likely to get reversed when lotteries are designed with an even division of the probability mass between the lowest and the highest outcomes. |
| Keywords: | Decision under risk; the Allais Paradox; Common Consequence Effect; Expected Utility; Fanning-out; Experimental Practices |
| JEL: | D01 D81 |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:swe:wpaper:2015-14&r=upt |
| By: | Matthieu Gilson; Kim Oosterlinck; Andrey Ukhov |
| Abstract: | Although of paramount importance in finance, empirical evidence on time-varying risk aversion remains mixed. This paper contributes to the existing literature by analyzing how investors’ risk preferences change under extreme circumstances. Using the market prices of a Belgian lottery bond, we build an index that tracks the attitude toward risk of financial markets’ participants during the Second World War. Results show that risk aversion dramatically changed during the Occupation period. Before 1943, investors showed strong signs of risk aversion; yet, in 1943 and 1944, they exhibited a risk-seeking attitude. After 1943, investors agreed to pay more and more for the lottery feature, and much more than the lottery’s expected payoff. In line with the behavioral finance literature, this puzzling result is attributed to psychological factors, most importantly the euphoria brought by the prospect of the war’s end. |
| Date: | 2015–07–31 |
| URL: | http://d.repec.org/n?u=RePEc:sol:wpaper:2013/207702&r=upt |
| By: | Sasha Prokosheva |
| Abstract: | I investigate the relationship between attitudes towards ambiguity and ability to reduce compound risks. The evidence from an experiment on adolescents shows that patterns identified in the previous literature are susceptible to experimental design and subject sample characteristics. Overall for a 20% of my subject sample, I do not observe a significant relationship between ambiguity-neutral behavior and reduction of compound lotteries. The relationship also varies with subjects' cognitive skills and the way lotteries are presented. My results caution about theoretical studies which model ambiguity preferences by relaxing the assumption of compound risk reduction, and add to the evidence against the use of compound lotteries to represent ambiguity in experiments. |
| Keywords: | ambiguity; cognitive ability; reduction of compound lotteries; |
| JEL: | C91 D81 |
| Date: | 2014–12 |
| URL: | http://d.repec.org/n?u=RePEc:cer:papers:wp525&r=upt |
| By: | Pierre-André Chiappori (Institute for Fiscal Studies and Columbia University); Monica Costa Dias (Institute for Fiscal Studies and Institute for Fiscal Studies); Costas Meghir (Institute for Fiscal Studies and Yale University) |
| Abstract: | We develop an equilibrium lifecycle model of education, marriage and labor supply and consumption in a transferable utility context. Individuals start by choosing their investments in education anticipating returns in the marriage market and the labor market. They then match based on the economic value of marriage and on preferences. Equilibrium in the marriage market determines intra-household allocation of resources. Following marriage households (married or single) save, supply labor and consume private and public under uncertainty. Marriage thus has the dual role of providing public goods and offering risk sharing. The model is estimated using the British HPS. |
| Date: | 2015–03 |
| URL: | http://d.repec.org/n?u=RePEc:ifs:cemmap:14/15&r=upt |
| By: | Rachel Griffith (Institute for Fiscal Studies and IFS and Manchester); Lars Nesheim (Institute for Fiscal Studies and cemmap and UCL); Martin O'Connell (Institute for Fiscal Studies) |
| Abstract: | Random utility models are widely used to study consumer choice. The vast majority of applications make strong assumptions about the marginal utility of income, which restricts income effects, demand curvature and pass-through. We show that flexibly modeling income effects can be important, particularly if one is interested in the distributional effects of a policy change, even in a market in which, a priori, the expectation is that income effects will play a limited role. We allow for much more flexible forms of income effects than is common and we illustrate the implications by simulating the introduction of an excise tax. Supplementary material for this paper is available here. |
| Keywords: | Income effects; compensating variation; demand estimation; oligopoly; pass-through |
| JEL: | L13 H20 |
| Date: | 2015–06 |
| URL: | http://d.repec.org/n?u=RePEc:ifs:cemmap:23/15&r=upt |
| By: | Jia Chen (Institute for Fiscal Studies); Degui Li (Institute for Fiscal Studies); Oliver Linton (Institute for Fiscal Studies and cemmap and Cambridge); Zudi Lu (Institute for Fiscal Studies) |
| Abstract: | Dynamic portfolio choice has been a central and essential objective for institutional investors in active asset management. In this paper, we study the dynamic portfolio choice depending on multiple conditioning variables, where the number of the conditioning variables can be either fixed or diverging to infinity at certain polynomial rate in comparison with the sample size. We propose a novel data-driven method to estimate the nonparametric optimal portfolio choice, motivated by the model averaging marginal regression approach suggested by Li, Linton and Lu (2014). Specifically, in order to avoid curse of dimensionality associated with the problem and to make it practically implementable, we first estimate the optimal portfolio choice by maximising the conditional utility function for each individual conditioning variable, and then construct the dynamic optimal portfolio choice through the weighted average of the marginal optimal portfolio across all the conditioning variables. Under some mild regularity conditions, we have established the large sample properties for the developed portfolio choice procedure. Both simulation studies and empirical application well demonstrate the performance of the proposed methodology with finite sample and real data. |
| JEL: | C13 C14 C32 |
| Date: | 2015–02 |
| URL: | http://d.repec.org/n?u=RePEc:ifs:cemmap:07/15&r=upt |
| By: | Olivier Blanchard; Christopher J. Erceg; Jesper Lindé |
| Abstract: | We show that a fiscal expansion by the core economies of the euro area would have a large and positive impact on periphery GDP assuming that policy rates remain low for a prolonged period. Under our preferred model specification, an expansion of core government spending equal to one percent of euro area GDP would boost periphery GDP around 1 percent in a liquidity trap lasting three years, about half as large as the effect on core GDP. Accordingly, under a standard ad hoc loss function involving output and inflation gaps, increasing core spending would generate substantial welfare improvements, especially in the periphery. The benefits are considerably smaller under a utility-based welfare measure, reflecting in part that higher net exports play a material role in raising periphery GDP. |
| JEL: | E62 F41 |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:21426&r=upt |
| By: | Marco Fongoni (Department of Economics, University of Strathyclyde); Alex Dickson (Department of Economics, University of Strathyclyde) |
| Abstract: | Concerns for fairness, workers' morale and reciprocity influence firms' wage setting policy. In this paper we formalize a theory of wage setting behavior in a simple and tractable model that explicitly considers these behavioral aspects. A worker is assumed to have reference-dependent preferences and displays loss aversion when evaluating the fairness of a wage contract. The theory establishes a wage-effort relationship that captures the worker's reference-dependent reciprocity, which in turn influences the firm's optimal wage policy. The paper makes two key contributions: it identifies loss aversion as an explanation for a worker's asymmetric reciprocity; and it provides realistic and generalized microfoundation for downward wage rigidity. We further illustrate the implications of our theory for both wage setting and hiring behavior. Downward wage rigidity generates several implications for the outcome of the initial employment contract. The worker's reference wage, his extent of negative reciprocity and the firms’ expectations are key drivers of the propositions derived. |
| Keywords: | reference dependence, loss aversion, morale, reciprocity, employment contract, downward wage rigidity, wage setting behavior |
| JEL: | C78 J30 J41 |
| Date: | 2015–07 |
| URL: | http://d.repec.org/n?u=RePEc:str:wpaper:1505&r=upt |
| By: | Le Yaouanq, Yves |
| Abstract: | This paper studies the consistency between a decision-maker's choices over menus in a first period and inside menus at a later date. The main result shows that the comparison of commitment decisions and actual subsequent choices reveals whether future taste contingencies are correctly anticipated: a sophisticated individual chooses exactly the right commitment options, whereas a naive decision-maker overlooks some profitable opportunities. The paper provides absolute and comparative measures of naivete and shows under which conditions pessimistic behavior can be attributed to the presence of self-control costs. Finally, I implement an experimental protocol based on the theoretical analysis and find substantial evidence of naivete at the individual level. |
| Keywords: | Self-control, Naivete, Temptation, Stochastic choice, Random Strotz |
| JEL: | C91 D81 D90 |
| Date: | 2015–06 |
| URL: | http://d.repec.org/n?u=RePEc:tse:wpaper:29461&r=upt |
| By: | Calleja, Pere; Llerena Garrés, Francesc |
| Abstract: | On the domain of cooperative transferable utility games, we investigate if there are single valued solutions that reconcile rationality, consistency and monotonicity (with respect to the worth of the grand coalition) properties. This paper collects some impossibility results on the combination of core selection with either complement or projected consistency, and core selection, max consistency and monotonicity. By contrast, possibility results show up when combining individual rationality, projected consistency and monotonicity. |
| Keywords: | Jocs cooperatius, 33 - Economia, |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:urv:wpaper:2072/247807&r=upt |
| By: | Pawel Dziewulski |
| Abstract: | The literature has documented a positive effect of foreign ownership on firm performance. But is this effect due to a one-time knowledge transfer or does it rely on continuous injections of knowledge? To shed light on this question we focus on divestments, that is, foreign affiliates that are sold to local owners. To establish a causal effect of the ownership change we combine a difference-in-differences approach with propensity score matching. We use plant-level panel data from the Indonesian Census of Manufacturing covering the period 1990-2009. We consider 157 cases of divestment, where a large set of plant characteristics is available two years before and three years after the ownership change and for which observationally similar control plants exist. The results indicate that divestment is associated with a drop in total factor productivity accompanied by a decline in output, markups as well as export and import intensity. The findings are consistent with the benefits of foreign ownership being driven by continuous supply of headquarter services from the foreign parent. |
| Keywords: | revealed preference, testable restrictions, rationalisation, time-preference, discounted utility, hyperbolic discounting, exponential discounting |
| JEL: | C14 C60 C61 D11 D12 |
| Date: | 2015–06–15 |
| URL: | http://d.repec.org/n?u=RePEc:oxf:wpaper:748&r=upt |