
on Utility Models and Prospect Theory 
Issue of 2019‒04‒08
ten papers chosen by 
By:  Anujit Chakraborty; Yoram Halevy; Kota Saito 
Abstract:  The paper establishes a tight relation between nonstandard behaviors in the domains of risk and time, by considering a decision maker with nonexpected utility preferences who believes that only present consumption is certain while any future consumption is uncertain. We provide the first complete characterizations of the twoway relations between the certainty effect and present biased temporal behavior, and between the common ratio effect and temporal reversals related to the common difference effect. 
Keywords:  time consistency, hyperbolic discounting, nonexpected utility, present bias, implicit risk. 
JEL:  D01 D81 D91 
Date:  2019–03–31 
URL:  http://d.repec.org/n?u=RePEc:tor:tecipa:tecipa633&r=all 
By:  Matteo Brachetta; Hanspeter Schmidli 
Abstract:  We consider a diffusion approximation to an insurance risk model where an external driver models a stochastic environment. The insurer can buy reinsurance. Moreover, investment in a financial market is possible. The financial market is also driven by the environmental process. Our goal is to maximise terminal expected utility. In particular, we consider the case of SAHARA utility functions. In the case of proportional and excessofloss reinsurance, we obtain explicit results. 
Date:  2019–03 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1903.12426&r=all 
By:  Katsutoshi WAKAI 
Abstract:  Based on the smooth model of decision making under ambiguity as proposed by Klibanoff, Marinacci, and Mukerji (2005, 2009), we derive a method that selects assets whose regression constant from the factor regression captures ambiguity premium. 
Keywords:  Ambiguity aversion, asset pricing, factor pricing 
JEL:  D81 G11 G12 
Date:  2019–03 
URL:  http://d.repec.org/n?u=RePEc:kue:epaper:e18009&r=all 
By:  van der Ploeg, Frederick; Rezai, Armon 
Abstract:  With the election of President Trump, climate deniers feel emboldened and moved from the fringes to the centre of global policy making. We study how an agnostic approach to policy, based on Pascal's wager and allowing for subjective prior probability beliefs about whether climate deniers are right, prices carbon. Using the DICE integrated assessment model, we find that assigning a 10% chance of climate deniers being correct lowers the global price on carbon in 2020 only marginally: from $21 to $19 per ton of carbon dioxide if policymakers apply "Nordhaus discounting" and from $91 to $84 per ton of carbon dioxide if they apply "Stern discounting". Agnostics' reflection of remaining scientific uncertainty leaves climate policy essentially unchanged. The robustness of an ambitious climate policy also follows from using the maxmin or the minmax regret principle. Letting the coefficient of relative ambiguity aversion vary from zero, corresponding to expected utility analysis, to infinity, corresponding to the maxmin principle, we show how policy makers deal with fundamental climate model uncertainty if they are prepared to assign prior probabilities to different views of the world being correct. Allowing for an ethical discount rate and a higher market discount rate and for a wide range of sensitivity exercises including damage uncertainty, we show that pricing carbon is the robust response under rising climate scepticism. 
Keywords:  climate model uncertainty, differential discount rates, climate scepticism, robust climate policies, maxmin, minmax regret, ambiguity aversion, DICE integrated assessment model 
Date:  2018–09 
URL:  http://d.repec.org/n?u=RePEc:wiw:wus045:6895&r=all 
By:  Larry G. Epstein; Yoram Halevy 
Abstract:  Decisions under uncertainty are often made with information that is difficult to interpret because multiple interpretations are possible. Individuals may perceive and handle uncertainty about interpretation differently and in ways that are not directly observable to a modeler. This paper identifies and experimentally examines behavior that can be interpreted as reflecting an individual's attitude towards such uncertainty. 
Keywords:  Ambiguity, updating, information, experiment 
JEL:  D81 D91 C91 
Date:  2019–03–31 
URL:  http://d.repec.org/n?u=RePEc:tor:tecipa:tecipa634&r=all 
By:  Aydogan, Ilke; Berger, Loϊc; Bosetti, Valentina; Liu, Ning 
Abstract:  We experimentally explore decisionmaking under uncertainty using a framework that decomposes uncertainty into three distinct layers: (1) physical uncertainty, entailing inherent randomness within a given probability model, (2) model uncertainty, entailing subjective uncertainty about the probability model to be used and (3) model misspecification, entailing uncertainty about the presence of the true probability model among the set of models considered. Using a new experimental design, we measure individual attitudes towards these different layers of uncertainty and study the distinct role of each of them in characterizing ambiguity attitudes. In addition to providing new insights into the underlying processes behind ambiguity aversion failure to reduce compound probabilities or distinct attitudes towards unknown probabilities our study provides the first empirical evidence for the intermediate role of model misspecification between model uncertainty and Ellsberg in decisionmaking under uncertainty. 
Keywords:  Risk and Uncertainty 
Date:  2018–07–10 
URL:  http://d.repec.org/n?u=RePEc:ags:feemth:274852&r=all 
By:  Andrew Caplin; John V. Leahy 
Abstract:  We model agents who get utility from their beliefs and therefore interpret information optimistically. They may exhibit several biases observed in psychological studies such as optimism, procrastination, confirmation bias, polarization, and the endowment effect. In some formulations, they exhibit these biases even though they are subjectively Bayesian. We argue that wishful thinking can lead to reduced saving, can make possible informationbased trade, and can generate asset bubbles. 
JEL:  D84 D91 
Date:  2019–03 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:25707&r=all 
By:  Xue Dong He; Moris S. Strub; Thaleia Zariphopoulou 
Abstract:  We introduce the concept of forward rankdependent performance processes, extending the original notion to forward criteria that incorporate probability distortions. A fundamental challenge is how to reconcile the timeconsistent nature of forward performance criteria with the timeinconsistency stemming from probability distortions. For this, we first propose two distinct definitions, one based on the preservation of performance value and the other on the timeconsistency of policies and, in turn, establish their equivalence. We then fully characterize the viable class of probability distortion processes, providing a bifurcationtype result. Specifically, it is either the case that the probability distortions are degenerate in the sense that the investor would never invest in the risky assets, or the marginal probability distortion equals to a normalized power of the quantile function of the pricing kernel. We also characterize the optimal wealth process, whose structure motivates the introduction of a new, distorted measure and a related market. We then build a striking correspondence between the forward rankdependent criteria in the original market and forward criteria without probability distortions in the auxiliary market. This connection also provides a direct construction method for forward rankdependent criteria. A byproduct of our work are some new results on the socalled dynamic utilities and on timeinconsistent problems in the classical (backward) setting. 
Date:  2019–04 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1904.01745&r=all 
By:  Bas B. Bakker; Marta Korczak; Krzysztof Krogulski 
Abstract:  In the last decade, over half of the EU countries in the euro area or with currencies pegged to the euro were hit by large risk premium shocks. Previous papers have focused on the impact of these shocks on demand. This paper, by contrast, focuses on the impact on supply. We show that risk premium shocks reduce the output level that maximizes profit. They also lead to unemployment surges, as firms are forced to cut costs when financing becomes expensive or is no longer available. As a result, all countries with risk premium shocks saw unemployment surge, even as euro area core countries managed to contain unemployment as firms hoarded labor during the downturn. Most striking, wage bills in euro area crisis countries and the Baltics declined even faster than GDP, whereas in core euro area countries wage shares actually increased. 
Date:  2019–03–18 
URL:  http://d.repec.org/n?u=RePEc:imf:imfwpa:19/56&r=all 
By:  Nasimeh Heydaribeni; Achilleas Anastasopoulos 
Abstract:  In the standard Mechanism Design framework, agents' messages are gathered at a central point and allocation/tax functions are calculated in a centralized manner, i.e., as functions of all network agents' messages. This requirement may cause communication and computation overhead and necessitates the design of mechanisms that alleviate this bottleneck. We consider a scenario where message transmission can only be performed locally so that the mechanism allocation/tax functions can be calculated in a decentralized manner. Each agent transmits messages to her local neighborhood, as defined by a given messageexchange network, and her allocation/tax functions are only functions of the available neighborhood messages. This scenario gives rise to a novel research problem that we call "Distributed Mechanism Design". In this paper, we propose two distributed mechanisms for network utility maximization problems that involve private and public goods with competition and cooperation between agents. As a concrete example, we use the problems of rate allocation in networks with either unicast or multirate multicast transmission protocols. The proposed mechanism for each of the protocols fully implements the optimal allocation in Nash equilibria and its message space dimensionality scales linearly with respect to the number of agents in the network. 
Date:  2019–04 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1904.01222&r=all 