nep-upt New Economics Papers
on Utility Models and Prospect Theory
Issue of 2016‒07‒23
33 papers chosen by
Alexander Harin
Modern University for the Humanities

  1. History-Dependent Risk Preferences: Evidence from Individual Choices and Implications for the Disposition Effect By Angie ANDRIKOGIANNOPOULOU; Filippos PAPAKONSTANTINOU
  2. Utilitarianism with and without expected utility By McCarthy, David; Mikkola, Kalle; Thomas, Teruji
  3. Theory Matters for Financial Advice! By Thorsten HENS; János MAYER
  4. Subjective Independence and Concave Expected Utility By Roee Teper
  5. Eliciting the just-noticeable difference By Pawel Dziewulski
  6. Subjective Independence and Concave Expected Utility By Roee Teper
  7. Cumulative Prospect Theory and Mean Variance Analysis: A Rigorous Comparison By Thorsten HENS; János MAYER
  8. Fashion, fads and the popularity of choices: micro-foundations for non-equilibrium consumer theory By Jean-Francois Mercure
  9. Super-Exponential Endogenous Bubbles in an Equilibrium Model of Fundamentalist and Chartist Traders By Taisei KAIZOJI; Matthias LEISS; Alexander I. SAICHEV; Didier SORNETTE
  10. Weak Dependence of CRRA on Standard Deviation in the Case of Truncated Normal Distribution of Returns By Fausto Corradin; Domenico Sartore
  11. Plans of Action By Roee Teper
  12. Dynamic Contracts Under Loss Aversion By Sofia Moroni
  13. Are Behavioral Biases Stable Across Markets and Prevalent Across Individuals? Evidence from Individual Betting Choices By Patrick GAGLIARDINI; Christian GOURIEROUX; Mirco RUBIN
  14. Nonparametric analysis of random utility models By Yuichi Kitamura; Jörg Stoye
  15. The Impact of Risk Attitudes on Financial Investments By Hyll, Walter; Irrek, Maike
  16. Testing Gollier and Weitzman’s Solution of the “Weitzman-Gollier Puzzle” By Szekeres, Szabolcs
  17. Goal Setting in the Principal-Agent Model: Weak Incentives for Strong Performance By Brice Corgnet; Joaquin Gomez-Minambres; Roberto Hernan-Gonzalez
  18. Evolutionary Behavioural Finance By Igor V. EVSTIGNEEV; Thorsten HENS; Klaus Reiner SCHENK-HOPPÉ
  19. Nonparametric Estimation of First-Price Auctions with Risk-Averse Bidders By Federico Zincenko
  20. Emotion Research in Economics By Klaus Wälde
  21. An ergodic BSDE approach to entropic risk measure and its large time behavior By Wing Fung Chong; Ying Hu; Gechun Liang; Thaleia Zariphopoulou
  22. Portfolio Delegation and Market Efficiency By Semyon MALAMUD; Evgeny PETROV
  23. Prospect Theory in the Heterogeneous Agent Model By Jan Polach; Jiri Kukacka
  24. Long/Short Equity Hedge Funds and Systematic Ambiguity By Rajna Gibson BRANDON; Nikolay RYABKOV
  25. Asset Prices with Temporary Shocks to Consumption By Walter POHL; Karl SCHMEDDERS; Ole WILMS
  26. The Common Origin of Uncertainty Shocks By Nicholas Kozeniauskas; Anna Orlik; Laura Veldkamp
  27. Noisy Arrow-Debreu Equilibria By Semyon MALAMUD
  28. Bankruptcy Problems with Reference-Dependent Preferences By Andrea Gallice
  29. Efficeincy Gains in Rank-ordered Multinomial Logit Models By Arie Beresteanu
  30. Hit or Miss? Test Taking Behavior in Multiple Choice Exams By Ş. Pelin Akyol; James Key; Kala Krishna
  31. Recommendation based on multiproduct utility maximization By Zhao, Qi; Zhang, Yongfeng; Zhang, Yi; Friedman, Daniel
  32. Trading with Small Price Impact By Ludovic MOREAU; Johannes MUHLE-KARBE; Halil Mete SONER
  33. Insurance valuation: a computable multi-period cost-of-capital approach By Hampus Engsner; Mathias Lindholm; Filip Lindskog

  1. By: Angie ANDRIKOGIANNOPOULOU (University of Geneva and Swiss Finance Institute); Filippos PAPAKONSTANTINOU (Imperial College London)
    Abstract: We use trading data from a sports wagering market to estimate individual risk preferences within the prospect-theory paradigm. The experimental-like features of this market greatly facilitate the estimation of risk preferences, while our long panel enables us to study whether preferences vary across individuals and depend on earlier outcomes. Our estimates i) extend support for existing experimental findings --- mild utility curvature, moderate loss aversion, and probability overweighting of extreme outcomes --- to a real market setting that shares similarities with traditional financial markets, ii) reveal that risk attitude is widely heterogeneous and history-dependent, and iii) indicate that prospect theory can better explain the prevalence of the disposition effect than previously thought.
    Keywords: Risk Preferences, State Dependence, History Dependence, Heterogeneity, Prospect Theory, Disposition Effect
    JEL: D03 D12 D14 D81 G02 G11
  2. By: McCarthy, David; Mikkola, Kalle; Thomas, Teruji
    Abstract: We give two social aggregation theorems under conditions of risk, one for constant population cases, the other an extension to variable populations. Intra and interpersonal comparisons are encoded in a single `individual preorder'. The individual preorder then uniquely determines the social preorder. The theorems have features that may be considered characteristic of Harsanyi-style utilitarianism, such as indifference to ex ante and ex post equality. If in addition the individual preorder satisfies expected utility, the social preorder must be represented by expected total utility. In the constant population case, this is the conclusion of the social aggregation theorem of Harsanyi (1955) under anonymity, but contra Harsanyi, it is derived without assuming expected utility at the social level. However, the theorems are also consistent with the rejection of all of the expected utility axioms, at both the individual and social levels. Thus expected utility is inessential to Harsanyi's approach under anonymity. In fact, the variable population theorem imposes only a mild constraint on the individual preorder, while the constant population theorem imposes no constraint at all. We therefore give further results related to additional constraints on the individual preorder. First, stronger utilitarian-friendly assumptions, like Pareto or strong separability, are essentially equivalent to the main expected utility axiom of strong independence. Second, the individual preorder satisfies strong independence if and only if the social preorder has a mixture-preserving total utility representation; here the utility values can be taken as vectors in a preordered vector space, or more concretely as lexicographically ordered matrices of real numbers. Third, if the individual preorder satisfies a `local expected utility' condition popular in nonexpected utility theory, then the social preorder is `locally utilitarian'.
    Keywords: Harsanyi, utilitarianism, expected utility, nonexpected utility, egalitarianism, variable populations.
    JEL: D60 D63 D71 D81
    Date: 2016–07–19
  3. By: Thorsten HENS (University of Zurich and Swiss Finance Institute); János MAYER (University of Zurich)
    Abstract: We show that the optimal asset allocation for an investor depends crucially on the theory with which the investor is modeled. For the same market data and the same client data different theories lead to different portfolios. The market data we consider is standard asset allocation data. The client data is determined by a standard risk profiling question and the theories we apply are mean-variance analysis, expected utility analysis and cumulative prospect theory.
    Keywords: Cumulative Prospect Theory, Expected Utility Analysis, Mean Variance Analysis
    JEL: C61 D81 G02 G11
  4. By: Roee Teper
    Abstract: When a potential hedge between alternatives does not reduce the exposureto uncertainty, we say that the decision maker considers these alternativesstructurally similar. We o er a novel approach and suggest that structural similarityis subjective and should be diff erent across decision makers. Structural similaritycan be recovered through a property of the individual's preferences referred to assubjective codecomposable independence. This property characterizes a class of event-separablemodels and allows us to diff erentiate between perception of uncertainty andattitude towards it. In addition, our approach provides a behavioral foundation toConcave Expected Utility preferences.
    Date: 2015–01
  5. By: Pawel Dziewulski
    Abstract: In this paper we provide the testable implications for the model of consumer choice with just-noticeable differences. A preference relation admits such a representation whenever there is a utility function u and a constant δ such that bundlex is preferred to y if and only if u(x)≥u(y)+δ. Equivalently,we say that the relation is a semiorder. We introduce a necessary and sufficient condition under whicha finite set of observations can be rationalised with the above model. Specifically, our restriction weakens the well-known generalised axiom of revealed preference,or GARP for short. In addition, we argue that the condition allows to determine an informative and computationally efficient measure of violations of GARP.
    Keywords: just-noticeable difference, revealed preference, Afriat's theorem, generalised budget sets, Afriat's efficiency index, money-pump index
    JEL: C14 C60 C61 D11 D12
    Date: 2016–07–06
  6. By: Roee Teper
    Abstract: When a potential hedge between alternatives does not reduce the exposureto uncertainty, we say that the decision maker considers these alternativesstructurally similar. We o er a novel approach and suggest that structural similarityis subjective and should be diff erent across decision makers. Structural similaritycan be recovered through a property of the individual's preferences referred to assubjective codecomposable independence. This property characterizes a class of event-separablemodels and allows us to diff erentiate between perception of uncertainty andattitude towards it. In addition, our approach provides a behavioral foundation toConcave Expected Utility preferences.
    Date: 2015–01
  7. By: Thorsten HENS (University of Zurich and Norwegian School of Economics and Business Administration and Swiss Finance Institute); János MAYER (University of Zurich)
    Abstract: We compare asset allocations that are derived for cumulative prospect theory (CPT) based on two different methods: maximizing CPT along the mean {variance efficient frontier and maximizing CPT without this restriction. We find that with normally distributed returns, the difference between these two approaches is negligible. However, if standard asset allocation data for pension funds are considered, the difference is considerable. Moreover, for certain types of derivatives, such as call options, the restriction of asset allocations to the mean-variance efficient frontier produces sizable losses in various respects, including decreases in expected returns and expected utility.
    Keywords: Cumulative Prospect Theory, Mean Variance Analysis
    JEL: C61 D81 G02 G11
  8. By: Jean-Francois Mercure
    Abstract: Knowledge acquisition by consumers is a key process in the diffusion of innovations. However, in standard theories of the representative agent, agents do not learn and innovations are adopted instantaneously. Here, we show that in a discrete choice model where utility-maximising agents with heterogenous preferences learn about products through peers, their stock of knowledge on products becomes heterogenous, fads and fashions arise, and transitivity in aggregate preferences is lost. Non-equilibrium path-dependent dynamics emerge, the representative agent exhibits behavioural rules different than individual agents, and aggregate utility cannot be optimised. Instead, an evolutionary theory of product innovation and diffusion emerges.
    Date: 2016–07
  9. By: Taisei KAIZOJI (International Christian University); Matthias LEISS (ETH Zurich); Alexander I. SAICHEV (ETH Zurich and Nizhni Novgorod State University); Didier SORNETTE (Swiss Finance Institute and ETH Zürich)
    Abstract: We introduce a model of super-exponential financial bubbles with two assets (risky and risk-free), in which fundamentalist and chartist traders co-exist. Fundamentalists form expectations on the return and risk of a risky asset and maximize their constant relative risk aversion expected utility with respect to their allocation on the risky asset versus the risk-free asset. Chartists are subjected to social imitation and follow momentum trading. Allowing for random time-varying herding propensity, we are able to reproduce several well-known stylized facts of financial markets such as a fat-tail distribution of returns and volatility clustering. In particular, we observe transient faster-than-exponential bubble growth with approximate log-periodic behavior and give analytical arguments why this follows from our framework. The model accounts well for the behavior of traders and for the price dynamics that developed during the dotcom bubble in 1995-2000. Momentum strategies are shown to be transiently profitable, supporting these strategies as enhancing herding behavior.
    Keywords: financial bubbles, faster-than-exponential growth, social imitation, momentum trading, chartists dotcom bubble
    JEL: C73 G01 G17
  10. By: Fausto Corradin; Domenico Sartore
    Abstract: This paper analyzes the dependence of the Certainty Equivalent Return of a Constant Relative Risk Aversion, CER[CRRA], on the Standard Deviation of the Return with the hypothesis of a Truncated Normal distribution of returns and for some level of Relative Risk Aversion (RRA) parameter. The paper compares this dependence with those detected by an Annualized Geometrical Return (AGR) and by CER of the Quadratic Utility Function, CER[Q]. The behavior of CER[CRRA] is more similar to AGR than CER[Q] and only for a higher value of RRA is it possible to find substantial differences, even if in this case we find values of Standard Deviation that have discontinuity points for the concavity. Using a ranking criteria equal to the one introduced by Morningstar for a set of Funds, the paper shows that, in a wide range for monthly Standard Deviation and Mean of the Returns, the ranking done by CER[CRRA] is similar to the one induced by AGR, and that a CER[Q] has essentially different behavior. It will be shown that Morningstar ranking may be considered a particular case of the CER[CRRA] and thus all the considerations can be applied to the well-known Morningstar Rating methodology. An application is made to Italian Pension Funds.
    Keywords: quadratic utility function, positive and negative returns, absolute risk aversion, Morningstar rating, Italian Pension Fund
    JEL: G11 G14 G24
    Date: 2016
  11. By: Roee Teper
    Abstract: We introduce a decision theoretic foundation for a class of learning models in which thedecision maker's beliefs over the present uncertainty is dictated by the outcomes of herpast actions. This type of learning underlies models of strategic experimentation. Weconstruct a framework in which an alternative is a recursive function contingent at anystage on the outcomes of previous actions, and provide axiomatizations for subjectivediscounted expected utility maximization, both for independent actions and correlatedactions. We point out that models of strategic experimentation have inherent limitedobservability, which in turn leads to partial identification of the subjective belief structure. We show that a class of processes we refer to as strongly exchangeable are the fullcharacterization of Bayesianism in such environments.
    Date: 2016–01
  12. By: Sofia Moroni
    Abstract: We analyze a dynamic moral hazard principal-agent model with an agent who is lossaverse and whose reference updates according to the previous period’s consumption.When there is full commitment and the agent has no access to credit, in every periodafter the first the optimal payment scheme is insensitive to the current outcome in an interval,offering to pay the reference for a set of performance measures. Therefore, thereis a positive probability of observing wage persistence even if outcomes vary over time.Moreover, the model predicts a “status quo bias†–a preference for consuming the fullallocation if the agent is allowed to intertemporally reallocate consumption after the outcomeis realized. This result in turn implies that unlike the canonical model, the optimalcontract may be implemented even when the agent has access to a savings technology.We use subdifferential calculus to address the non-differentiable utility function.
    Date: 2016–01
  13. By: Patrick GAGLIARDINI (University of Lugano and Swiss Finance Institute); Christian GOURIEROUX (CREST and University of Toronto); Mirco RUBIN (University of Lugano and Swiss Finance Institute)
    Abstract: In this paper we introduce and study positional portfolio management. In a positional allocation strategy, the manager maximizes an expected utility function written on the cross-sectional rank (position) of the portfolio return. The objective function reflects the goal of the manager to be well ranked among his/her competitors. To implement positional allocation strategies, we specify a nonlinear unobservable factor model for the asset returns. The model disentangles the dynamic of the cross-sectional distribution of the returns and the dynamic of the ranks of the individual assets within the cross-sectional distribution. We estimate the model on a large set of stocks traded in the NYSE, AMEX and NASDAQ markets between 1990/1 and 2009/12, and implement the positional strategies for different investment universes. The positional strategies outperform standard momentum, reversal and mean-variance allocation strategies for most criteria. Moreover, the positional strategies outperform the equally weighted portfolio for criteria based on position.
    Keywords: Positional Good, Robust Portfolio Management, Rank, Factor Model, Big Data, Equally Weighted Portfolio, Momentum, Positional Risk Aversion
    JEL: C38 C55 G11
  14. By: Yuichi Kitamura (Institute for Fiscal Studies and Yale University); Jörg Stoye (Institute for Fiscal Studies and New York University)
    Abstract: This paper develops and implements a nonparametric test of Random Utility Models. The motivating application is to test the null hypothesis that a sample of cross-sectional demand distributions was generated by a population of rational consumers. We test a necessary and sucient condition for this that does not rely on any restriction on unobserved heterogeneity or the number of goods. We also propose and implement a control function approach to account for endogenous expenditure. An econometric result of independent interest is a test for linear inequality constraints when these are represented as the vertices of a polyhedron rather than its faces. An empirical application to the U.K. Household Expenditure Survey illustrates computational feasibility of the method in demand problems with 5 goods.
    JEL: C14
    Date: 2016–06–14
  15. By: Hyll, Walter; Irrek, Maike
    Abstract: Several scholars analyze the relationship between individuals' willingness to take risks and financial investment decisions. We add to this literature in using data from the German Socio-Economic Panel which allow ruling out that investments in risky assets itself impact on risk attitudes. We show that individuals with a higher willingness to take risks are more likely to hold bonds, stocks, and company assets. When grouping individuals into risk groups, our results reveal that high risk takers are also less likely to own a life insurance. If endogenous adaption of risk attitudes from holding assets in previous years is not taken into account, the impact of risk attitudes on holding risky assets is upward biased.
    Keywords: risk attitudes,financial investment,portfolio choice,reverse causality,German Socio-Economic Panel
    JEL: D14 D81 G11
    Date: 2015
  16. By: Szekeres, Szabolcs
    Abstract: Despite the fact that the “Weitzman-Gollier Puzzle” arose in the context of risk neutrality, Gollier and Weitzman (2009) claimed to have solved the puzzle by showing that, in case of risk aversion, discounting and compounding approaches yield the same result, and that these can be expressed in ways that are morphologically similar to the conflicting formulations of the original risk neutral model. This paper replicates their analysis with a simple numerical example and shows that the equality of results obtained is due to discount and compound factors being each other’s reciprocals in the risk averse model, while the inequality of the puzzle is due to this condition not being met in the risk neutral case. Their claim to have solved the puzzle is not sustained. It is shown that the source of the puzzle is Weitzman’s incorrect specification of the present value factor and that, correcting for this, the right conclusion under his assumptions is that certainty equivalent discount rates are growing functions of time. Gollier and Weitzman (2009) also claimed that “the ‘effective’ discount rate must decline over time toward its lowest possible value.” This paper finds that when long term market yields are a growing function of time, it makes no sense to invest in projects of similar risk but lesser yield, irrespective of one’s degree of risk aversion.
    Keywords: Discounting, uncertainty, "Weitzman-Gollier Puzzle"
    JEL: D61 H43
    Date: 2016–07–17
  17. By: Brice Corgnet (Economic Science Institute, Argyros School of Business and Economics); Joaquin Gomez-Minambres (Bucknell University, Department of Economics,); Roberto Hernan-Gonzalez (Business School, University of Nottingham)
    Abstract: We study a principal-agent framework in which principals can assign wage-irrelevant goals to agents. We find evidence that, when given the possibility to set wage-irrelevant goals, principals select incentive contracts for which pay is less responsive to agents’ performance. Agents’ performance is higher in the presence of goal setting despite weaker incentives. We develop a principal-agent model with reference-dependent utility that illustrates how labor contracts combining weak monetary incentives and wage-irrelevant goals can be optimal. The pervasive use of non-monetary incentives in the workplace may help account for previous empirical findings suggesting that firms rely on unexpectedly weak monetary incentives.
    Keywords: Principal-agent models, incentive theory, non-monetary incentives, goal setting, reference-dependent utility, laboratory experiments.
    Date: 2016–09
  18. By: Igor V. EVSTIGNEEV (University of Manchester); Thorsten HENS (University of Zürich and Swiss Finance Institute); Klaus Reiner SCHENK-HOPPÉ (University of Manchester)
    Abstract: The paper reviews a new research field that develops evolutionary and behavioural approaches for the modeling of financial markets. The main objective is to create a plausible alternative to the conventional Walrasian equilibrium theory based on the hypothesis of full rationality of market players. Rather than maximizing typically unobservable individual utility functions, traders/investors are permitted to have a whole variety of patterns of strategic behaviour depending on their individual psychology. The models considered in this field combine elements of evolutionary game theory (solution concepts) and stochastic dynamic games (strategic frameworks).
  19. By: Federico Zincenko
    Abstract: This paper proposes nonparametric estimators for the bidders' utility function and density of private values in a first-price sealed-bid auction model with independent valuations. I study a setting with risk-averse bidders and adopt a fully nonparametric approach by not placing any restrictions on the shape of the utility function beyond regularity conditions. I propose a population criterionfunction that has a unique minimizer, which characterizes the utility function and density of private values. The resulting estimators emerge after replacing the population quantities by sample analogues. These estimators are uniformly consistent and their convergence rates are established. Monte Carlo experiments show that the proposed estimators perform well in practice.
    Date: 2016–01
  20. By: Klaus Wälde (Johannes Gutenberg-University Mainz)
    Abstract: Emotions were central to the development of economics, especially in utility theory in classical economics. While neoclassical utility theory basically abolished emotions, behavioural economics more recently reintroduced emotions in utility theory. Beyond utility theory, economic theorists use emotions to explain behaviour which otherwise could not be understood or they study emotions out of interest for the emotion itself. While some analyses display a strong overlap between psychological thinking and economic modelling, in most cases there is still a large gap between economic and psychological approaches to emotion research. Ways how to reduce this gap are discussed.
    Keywords: utility theory, ex-ante emotions, immediate emotions, ex-post emotions belief-based emotions, regret, desire, stress, anxiety, guilt
    Date: 2016–06
  21. By: Wing Fung Chong; Ying Hu; Gechun Liang; Thaleia Zariphopoulou
    Abstract: This paper shows that the long-time behavior of the entropic risk measure (under both forward performance process framework and classical utility framework) converges to a constant, which is independent of the initial state of the stochastic factors in a stochastic factor model. The exponential convergence rate to the long-term limit is also obtained by using ergodic backward stochastic differential equation method. Finally, the paper establishes a connection between the two notions of entropic risk measures and their large time behavior.
    Date: 2016–07
  22. By: Semyon MALAMUD (Ecole Polytechnique Fédérale de Lausanne and Swiss Finance Institute); Evgeny PETROV (Ecole Polytechnique Fédérale de Lausanne and Swiss Finance Institute (PhD Program))
    Abstract: We develop a two-period general equilibrium model of portfolio delegation with competitive, differentially skilled managers and convex compensation contracts. We show that convex incentives lead to significant equilibrium mispricing, but reduce price volatility. In particular, price informativeness and volatility may exhibit opposite behaviour. Investors do not internalize the externality that their contract choice has on equilibrium prices. As a result, equilibrium incentives may be too strong or too weak and hurt investors as a whole. For example, investors' utility may be decreasing in the average managers' skill. Convex incentives amplify this negative externality. Indirect incentives due to future fund flows may induce investors to choose stronger convex direct incentives, amplifying inefficiencies even further. Inference of skill from performance is asymmetric: past bad performance is indicative of low skill, but past good performance is not indicative of high skill.
    Keywords: portfolio delegation, optimal incentives, contracts, asymmetric information, informational efficiency
    JEL: G14 D86 G23 D53
  23. By: Jan Polach (London School of Economics and Political Science, Houghton Street, London WC2A 2AE, United Kingdom); Jiri Kukacka (Institute of Economic Studies, Faculty of Social Sciences, Charles University in Prague, Smetanovo nabrezi 6, 111 01 Prague 1, Czech Republic; Institute of Information Theory and Automation, Academy of Sciences of the Czech Republic, Pod Vodarenskou Vezi 4, 182 00, Prague, Czech Republic)
    Abstract: Using the Heterogeneous Agent Model framework, we incorporate an extension based on Prospect Theory into a popular agent-based asset pricing model. The extension covers the phenomenon of loss aversion manifested in risk aversion and asymmetric treatment of gains and losses. Using Monte Carlo methods, we investigate behavior and statistical properties of the extended model and assess its relevance with respect to financial data and stylized facts. We show that the Prospect Theory extension keeps the essential underlying mechanics of the model intact, however, that it changes the model dynamics considerably. Stability of the model increases but the occurrence of the fundamental strategy is more extreme. Moreover, the extension shifts the model closer to the behavior of real-world stock markets.
    Keywords: Heterogeneous Agent Model, Prospect Theory, Behavioral Finance, Stylized facts
    JEL: C1 C61 D84 G12
    Date: 2016–07
  24. By: Rajna Gibson BRANDON (University of Geneva and Swiss Finance Institute); Nikolay RYABKOV (University of Zurich and Swiss Finance Institute)
    Abstract: This study presents a hedge fund portfolio choice model for an investor facing ambiguity. In the empirical section, we measure ambiguity as the cross-sectional dispersion in Industrial Production growth and in stock market return forecasts, and we construct the systematic ambiguity factors from the universe of S&P 500 stocks. We estimate ambiguity betas for long/short equity hedge funds strategies and document signi cant ambiguity exposures for directional L/S equity hedge funds. We compare the out-of-sample performance of portfolios constructed according to the L/S hedge fund alphas' ranking with and without systematic ambiguity exposures and nd that the former outperform.
    Keywords: Ambiguity, Asset Allocation, Long/Short Equity Hedge Funds, Performance Measurement
    JEL: G11
  25. By: Walter POHL (University of Zurich); Karl SCHMEDDERS (University of Zurich and Swiss Finance Institute); Ole WILMS (University of Zurich)
    Abstract: Most standard asset-pricing models assume that all shocks to consumption are permanent. We relax this assumption and allow also for temporary shocks. The implications of our model are dramatically different from those obtained in the prior literature. A canonical and parsimonious asset pricing model with CRRA preferences and temporary shocks can reproduce the equity premium, high return volatility and return predictability with a coefficient of relative risk aversion below ten. This finding suggests that temporary shocks can play an important role in explaining asset pricing puzzles.
    Keywords: Asset prices, equity premium, unit root, temporary shocks
    JEL: G11 G12
  26. By: Nicholas Kozeniauskas; Anna Orlik; Laura Veldkamp
    Abstract: Various types of uncertainty shocks can explain many phenomena in macroeconomics and finance. But does this just amount to inventing new, exogenous, unobserved shocks to explain challenging features of business cycles? This paper argues that three conceptually distinct fluctuations, all called uncertainty shocks, have a common origin. Specifically, we propose a mechanism that generates micro uncertainty (uncertainty about firm-level shocks), macro uncertainty (uncertainty about aggregate shocks) and higher-order uncertainty (disagreement) shocks from a common origin and causes them to covary, just as they do in the data. When agents use standard maximum likelihood techniques and real-time data to re-estimate parameters that govern the probability of disasters, the result is that micro, macro and higher-order uncertainty fluctuate and covary just like their empirical counterparts. Our findings suggest that time-varying disaster risk and the many types of uncertainty shocks are not distinct phenomena. They are outcomes of a quantitatively plausible belief updating process.
    JEL: E0
    Date: 2016–07
  27. By: Semyon MALAMUD (EPFL and Swiss Finance Institute)
    Abstract: I develop a noisy rational expectations equilibrium model with a continuum of states and a full set of options that render the market complete. I show a major difference in equilibrium behaviour between models with constant absolute risk aversion (CARA) and non-CARA preferences. First, when informed traders have non-CARA preferences, all equilibria are fully revealing, independent of the amount of noise in the supply. Second, when informed traders have CARA preferences, but uninformed traders have non-CARA preferences, the set of equilibria contains a fully revealing equilibrium and a minimally revealing equilibrium. The latter reveals the minimal possible amount of information and is highly inefficient: In this equilibrium, Arrow-Debreu state prices are not sufficient to recover the information contained in the noisy aggregate demand and supply. My results have important implications for price discovery through options.
    Keywords: asymmetric information, options, price discovery, Arrow-Debreu state prices
    JEL: G14 G13 D82
  28. By: Andrea Gallice (Department of Economics and Statistics (Dipartimento di Scienze Economico-Sociali e Matematico-Statistiche), University of Torino, Italy)
    Abstract: We study bankruptcy problems under the assumption that claimants have reference-dependent preferences. We show that in such a context, standard allocative rules are no longer equivalent from the viewpoint of the level of welfare that they generate. A clear ranking of the most prominent rules actually emerges. Welfare thus becomes an additional dimension that an arbitrator may want to consider in deciding which allocation to implement. We then introduce a new rule that always maximizes welfare and discuss its pros and cons.
    Keywords: Bankruptcy Problems, Claims, Reference-Dependent Preferences, Welfare.
    JEL: D63 D03
    Date: 2016–07
  29. By: Arie Beresteanu
    Abstract: This paper considers estimation of discrete choice models when agents report their rankingof the alternatives (or some of them) rather than just the utility maximizing alternative. Weinvestigate the parametric conditional rank-ordered Logit model. We show that conditionsfor identifi cation do not change even if we observe ranking. Moreover, we ll a gap in theliterature and show analytically and by Monte Carlo simulations that efficiency increases as weuse additional information on the ranking.
    Date: 2016–01
  30. By: Ş. Pelin Akyol; James Key; Kala Krishna
    Abstract: We model and estimate the decision to answer questions in multiple choice tests with negative marking. Our focus is on the trade-off between precision and fairness. Negative marking reduces guessing, thereby increasing accuracy considerably. However, it reduces the expected score of the more risk averse, discriminating against them. Using data from the Turkish University Entrance Exam, we find that students' attitudes towards risk differ according to their gender and ability. Women and those with high ability are significantly more risk averse: nevertheless, the impact on scores of such differences is small, making a case for negative marking.
    JEL: I21 J24 D61 C11
    Date: 2016–07
  31. By: Zhao, Qi; Zhang, Yongfeng; Zhang, Yi; Friedman, Daniel
    Abstract: Recommender systems often recommend several products to a user at the same time, but with little consideration of the relationships among the recommended products. We argue that relationships such as substitutes and complements are crucial, since the utility of one product may depend on whether or not other products are purchased. For example, the utility of a camera lens is much higher if the user has the appropriate camera (complements), and the utility of one camera is lower if the user already has a similar camera (substitutes). In this paper, we propose multi-product utility maximization (MPUM) as a general approach to account for product relationships in recommendation systems. MPUM integrates the economic theory of consumer choice theory with personalized recommendation, and explicitly considers product relationships. It describes and predicts utility of product bundles for individual users. Based on MPUM, the system can recommend products by considering what the users already have, or recommend multiple products with maximum joint utility. As the estimated utility has mon- etary unit, other economic based evaluation metrics such as consumer surplus or total surplus can be incorporated naturally. We evaluate MPUM against several popular base- line recommendation algorithms on two offline E-commerce datasets. The experimental results showed that MPUM significantly outperformed baseline algorithm under top-K evaluation metric, which suggests that the expected number of accepted/purchased products given K recommendations are higher.
    Keywords: Recommendation Systems,Utility,Product Portfolio,Computational Economics
    Date: 2016
  32. By: Ludovic MOREAU (ETH Zurich); Johannes MUHLE-KARBE (ETH Zurich and Swiss Finance Institute); Halil Mete SONER (ETH Zurich and Swiss Finance Institute)
    Abstract: An investor trades a safe and several risky assets with linear price impact to maximize expected utility from terminal wealth. In the limit for small impact costs, we explicitly determine the optimal policy and welfare, in a general Markovian setting allowing for stochastic market, cost, and preference parameters. These results shed light on the general structure of the problem at hand, and also unveil close connections to optimal execution problems and to other market frictions such as proportional and fixed transaction costs.
    Keywords: price impact, portfolio choice, asymptotics, homogenization
    JEL: G11
  33. By: Hampus Engsner; Mathias Lindholm; Filip Lindskog
    Abstract: We present an approach to market-consistent multi-period valuation of insurance liability cash flows based on a two-stage valuation procedure. First, a portfolio of traded financial instrument aimed at replicating the liability cash flow is fixed. Then the residual cash flow is managed by repeated one-period replication using only cash funds. The latter part takes capital requirements and costs into account, as well as limited liability and risk averseness of capital providers. The cost-of-capital margin is the value of the residual cash flow. We set up a general framework for the cost-of-capital margin and relate it to dynamic risk measurement. Moreover, we present explicit formulas and properties of the cost-of-capital margin under further assumptions on the model for the liability cash flow and on the conditional risk measures and utility functions. Finally, we highlight computational aspects of the cost-of-capital margin, and related quantities, in terms of an example from life insurance.
    Date: 2016–07

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