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on Utility Models and Prospect Theory |
| By: | Florian Schneider; Martin Schonger |
| Abstract: | Most models of ambiguity aversion satisfy Anscombe-Aumann’s Monotonicity axiom. This paper proposes a test of Monotonicity, the Allais Horse Race. It is an adaptation of the Allais paradox to a setting with both subjective and objective uncertainty. Viewed as a thought experiment, the Allais Horse Race allows for introspective assessment of Monotonicity. Imple- menting it as an incentivized experiment, we find that the modal choice of subjects violates Monotonicity in a specific, intuitive way. Overall, we find that models of ambiguity aversion that satisfy Monotonicity cannot describe the behavior of about half of all subjects. |
| Keywords: | Ambiguity aversion, monotonicity, Anscombe-Aumann, Allais paradox, experiments |
| JEL: | D81 |
| Date: | 2015–10 |
| URL: | http://d.repec.org/n?u=RePEc:zur:econwp:207&r=all |
| By: | Georges Hübner (Deloitte Chaired Professor of Portfolio Management and Performance, HEC Management School - University of Liège, Rue Louvrex 14 - N1, B-4000 Liège, Belgium); Thomas Lejeune (Research Department, NBB) |
| Abstract: | The paper proposes an innovative framework for characterizing investors' behavior in portfolio selection. The approach is based on the realistic perspective of unknown investors' utility and incomplete information on returns distribution. Using a four-moment generalization of the Chebyshev inequality, an intuitive risk measure, risk horizon, is introduced with reference to the speed of convergence of a portfolio's mean return to its expectation. Empirical implementation provides evidence on the consistency of the approach with standard portfolio criteria such as, among others, the Sharpe ratio, a shortfall probability decay-rate optimization and a general class of flexible three-parameter utility functions. |
| Keywords: | Portfolio choice, risk-return trade-off, horizon |
| JEL: | G11 G12 C14 |
| Date: | 2015–10 |
| URL: | http://d.repec.org/n?u=RePEc:nbb:reswpp:201510-289&r=all |
| By: | Koç, Emre (Tilburg University, School of Economics and Management) |
| Abstract: | In this thesis several different aspects of the standard economic theory (SET) are examined. One of the premises of the SET is that whether or not an agent has choice flexibility does not influence his behavior. In the first chapter of the thesis we design an experiment to test the validity of this claim. We find that subjects behave in a way that justifies their earlier choices and therefore, choice flexibility does affect behavior. <br/>The standard economic framework is commonly used to examine consumption behavior of individuals and households. According to the SET, consumption growth is unchanged when a worker loses his job or when an unemployed individual finds a job as long as the transition event is anticipated. In the second chapter of this thesis we test this particular prediction of the SET. We use self-reported expectations of individuals to measure how much they anticipate a given transition. We find that consumption behavior is compatible with the SET.<br/>Internal consistency of preferences is another important premise of the SET. In the third and fourth chapters, we are interested in the question of whether decision makers have inconsistent time preferences and if so whether they behave in a sophisticated manner. To investigate these issues we conduct a two-stage experiment, where choices made in the first stage could affect the choices that will be available to the subject in the second stage. We find that the majority of our subjects have inconsistent preferences and roughly half of them exhibit sophisticated behavior. In the fourth chapter we consider the roles of uncertainty and the decision makers’ preference for choice flexibility. We find that uncertainty plays an important role and our subjects tend to avoid making a choice in the second stage.<br/> |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:tiu:tiutis:99d3bd3a-3df3-4994-971f-6d4d687988e8&r=all |
| By: | Thomas Eisenbach (Federal Reserve Bank of New York); Martin Schmalz (University of Michigan); Marianne Andries (Toulouse School of Economics) |
| Abstract: | We study general equilibrium asset prices in a multi-period endowment economy when agents' risk aversion is allowed to depend on the maturity of the risk. In our pseudo-recursive preference framework, agents are time inconsistent for their intra- temporal decision making, though time consistent for inter-temporal decisions. We find, in the absence of jumps and under log-normal consumption growth, horizon- dependent risk aversion preferences affect the term structure of risk premia if and only if volatility is stochastic. When risk aversion decreases with the horizon (as lab experiments indicate), and the elasticity of intertemporal substitution is greater than one, our model results in a downward slopping (in absolute value) pricing of volatility risk, which, in turns, can explain the recent empirical results on the term structure of risky asset returns. We confirm this prediction using index options data. |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed015:1069&r=all |
| By: | Zachary Feinstein; Birgit Rudloff |
| Abstract: | The equivalence between multiportfolio time consistency of a dynamic multivariate risk measure and a supermartingale property is proven. Furthermore, the dual variables under which this set-valued supermartingale is a martingale are characterized as the worst-case dual variables in the dual representation of the risk measure. Examples of multivariate risk measures satisfying the supermartingale property are given. |
| Date: | 2015–10 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1510.05561&r=all |
| By: | Kuzmin, Evgeny A.; Semyonovykh, Sergei M. |
| Abstract: | A behaviour of economic agents in many respects depends on taking into account those conditions that have appeared around them. Traditionally, to such conditions, researchers have referred the uncertainty and factors of the institutional control, often projected on a value of the transaction costs. Studies in stimulants for any form of the agents’ behaviour lead us to an analysis of the Coase theorem, which is expected to explain a number of similar regularities. However, ambiguous approaches to the theorem interpretation generate conflicts in a perception and identification of externalities. It is a solution to this challenge, which is a focus of this research. In a critical review of works by Coase and his followers, the theorem statement has been made clearer; we have also put forward a hypothesis on an origin of the externalities and introduced additional criteria to identify them. The paper has given a scientific rationale for an author's assumption that the utility of impure goods depends on the vector of the externalities, which ultimately determines the stratification in a field of the externalities (positive or negative). |
| Keywords: | Externalities, Coase Theorem, Uncertainty |
| JEL: | A11 B25 B40 |
| Date: | 2015–10 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:67350&r=all |
| By: | Gerasimou, Georgios |
| Abstract: | Three reasons why decision makers may defer choice are *indecisiveness* between feasible options, *unattractiveness* of these options and *choice overload*. This paper provides a choice-theoretic explanation for each of these phenomena by means of three deferral-permissive models of decision making that are driven by preference incompleteness, undesirability and complexity constraints, respectively. These models feature *rational* choice deferral in the sense that whenever the individual does choose an option from a menu, this is a most preferred option in that menu, so that choices are always WARP-consistent. The models also allow for the use of observable data to recover the individual's preferences and, where applicable, the indecisiveness and undesirability components of these preferences. |
| Keywords: | Choice deferral; incomplete preferences; indecisiveness; unattractiveness; choice overload; revealed preference. |
| JEL: | D01 D03 D11 |
| Date: | 2015–10 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:67290&r=all |
| By: | Bruno Feunou; Mohammad R. Jahan-Parvar; Cédric Okou |
| Abstract: | We decompose the variance risk premium into upside and downside variance risk premia. These components reflect market compensation for changes in good and bad uncertainties. Their difference is a measure of the skewness risk premium (SRP), which captures asymmetric views on favorable versus undesirable risks. Empirically, we establish that the downside variance risk premium (DVRP) is the main component of the variance risk premium. We find a positive and significant link between the DVRP and the equity premium, and a negative and significant relation between the SRP and the equity premium. A simple equilibrium consumption-based asset pricing model supports our decomposition. |
| Keywords: | Asset pricing |
| JEL: | G G1 G12 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:bca:bocawp:15-36&r=all |
| By: | Renaud Bourlès (AMSE - Aix-Marseille School of Economics - EHESS - École des hautes études en sciences sociales - Centre national de la recherche scientifique (CNRS) - Ecole Centrale Marseille (ECM) - AMU - Aix-Marseille Université) |
| Abstract: | Long-term insurance contracts are widespread, particularly in public health and the labor market. Such contracts typically involve monthly or annual premia which are related to the insured’s risk profile, where a given profile might change based on observed outcomes which depend on the insured’s prevention efforts. The aim of this paper is to analyze the latter relationship. In a two-period optimal insurance contract in which the insured’s risk profile is partly governed by the effort he puts on prevention, we find that both the insured’s risk aversion and prudence play a crucial role. If absolute prudence is greater than twice absolute risk aversion, moral hazard justifies setting a higher premium in the first period but also greater premium discrimination in the second period. For specific utility functions, moreover, an increase in the gap between prudence and risk aversion increases the initial premium and the subsequent premium discrimination. These results provide insights on the tradeoffs between long-term insurance and the incentives for primary prevention arising from risk classification, as well as between inter- and intra-generational insurance. |
| Keywords: | long-term insurance, classification risk, moral hazard, prudence |
| Date: | 2015–10 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:halshs-01214592&r=all |
| By: | Roman M. Sheremeta (Weatherhead School of Management, Case Western Reserve University and Economic Science Institute, Chapman University) |
| Abstract: | Group contests are ubiquitous. Some examples include warfare between countries, competition between political parties, team-incentives within firms, group sports, and rent-seeking. In order to succeed, members of the same group have incentives to cooperate with each other by expending individual efforts. However, since effort is costly, each member also has an incentive to abstain from expending any effort and instead free-ride on the efforts of other members. Contest theory shows that the intensity of competition between groups and the amount of freeriding within groups depend on the group size, sharing rule, group impact function, contest success function, and heterogeneity of players. We review experimental studies testing these theoretical predictions. Almost all studies of behavior in group contests find significant overexpenditure of effort relative to the theory. We discuss potential explanations for such overexpenditure, including the utility of winning, bounded rationality, relative payoff maximization, parochial altruism, and social identity. Despite over-expenditure, most studies find support for the comparative statics predictions of the theory (with the exception of the “group size paradox”). Finally, studies show that there are effective mechanisms that can promote withingroup cooperation and conflict resolution mechanisms that can de-escalate and potentially eliminate between-group conflict. |
| Keywords: | groups, contests, experiments |
| JEL: | C7 C9 D7 H4 J4 K4 L2 M5 |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:chu:wpaper:15-21&r=all |
| By: | Renate Buijze (Erasmus University Rotterdam (EUR) - Erasmus School of Law); Christoph Engel (Max Planck Institute for Research on Collective Goods, Bonn); Sigrid Hemels (Erasmus University Rotterdam (EUR) - Erasmus School of Law) |
| Abstract: | An increasing fraction of donations is channeled through donation intermediaries. These entities serve multiple purposes, one of which seems to be providing donors with greater certainty: that the donation reaches its intended goal, and that the donor may be sure to get a tax benefit. We interpret this function as insurance and test the option to insure donations in the lab. Our participants indeed have a positive willingness to pay for insurance against either risk. Yet the insurance option is only critical for their willingness to donate to a charity if the uncertainty affects the proper use of their donation. |
| Keywords: | Insurance, charity, Donation, donation intermediary |
| JEL: | D64 H25 D03 H31 D12 G22 K34 L31 |
| Date: | 2015–10 |
| URL: | http://d.repec.org/n?u=RePEc:mpg:wpaper:2015_16&r=all |
| By: | Pedro Silos (Federal Reserve Bank of Atlanta); German Cubas (University of Houston) |
| Abstract: | Is risk priced in the labor market? We document a strong, robust, and positive correlation between average earnings and the variance of both temporary and permanent idiosyncratic shocks to earnings across 21 US industries. However, since workers are heterogeneous in their abilities, the correlation may be entirely driven by selection. What portion of the correlation is compensation for risk and what portion is compensation for unobserved abilities? We construct an equilibrium model with imperfect insurance of labor earnings shocks. The variance of shocks varies across industries. An industry-specific ability drives a worker's comparative advantage, which interacts with her risk aversion to determine an optimal career choice. We find that permanent shocks are highly priced, whereas temporary shocks are not. Two additional results arise. First, workers accumulate different levels of wealth depending on the employment industry. Second, compensation for risk explains a sizable fraction of observed cross-industry differences in labor earnings. |
| Date: | 2015 |
| URL: | http://d.repec.org/n?u=RePEc:red:sed015:1036&r=all |
| By: | D'Orlando, Fabio; Ferrante, Francesco |
| Abstract: | Traditional theoretical literature which neglects the benefits of stabilization policies (e.g., Lucas 1987 and 2003) ultimately relies on the small impact that macroeconomic volatility has on aggregate income and consumption. In this article, we argue that such an approach is both theoretically and empirically weak. From the theoretical viewpoint, the cost of volatility should be measured including not only monetary magnitudes, but also those psychological costs whose relevance has been stressed by behavioural economics and which are correlated with the number of unemployment episodes. We refer here to the implications for experienced utility of loss aversion, the endowment effect and hedonic adaptation. This theoretical problem is coupled with the empirical finding that the effects of downturns are not randomly distributed and serially uncorrelated, i.e., they affect more frequently those who have less (in terms of skills, income and wealth) and who suffer greater wellbeing losses from each shock. It follows that the traditional (and Lucas) analysis disregards the main causes of wellbeing losses determined by downturns. Hence, it cannot be considered as a theoretically sound basis for denying the usefulness of policies aimed at preventing downturns and/or of micro regulation policies aimed at preventing the impact of downturns and labour force reallocation on the labour market. |
| Keywords: | Behavioural economics, employment protection legislation, endowment effect, hedonic adaptation, loss aversion, recessions, redistribution, unemployment |
| JEL: | E24 E32 I38 J63 J65 J68 |
| Date: | 2015–10–18 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:67321&r=all |