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on Utility Models and Prospect Theory |
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Issue of 2019‒04‒15
twelve papers chosen by |
| By: | Hasan Fallahgoul (Monash University); Loriano Mancini (USI Lugano - Institute of Finance; Swiss Finance Institute); Stoyan V. Stoyanov (Stony Brook University) |
| Abstract: | Extensions of utility functions sensitive to the tail behavior of the portfolio return distribution may not be approximated reliably through higher-order moment expansions and require specifying a complete distribution. This, however, implies that an optimal allocation can be adversely influenced by an incorrect distribution specification. We develop a novel approach for model risk assessment based on a projection method which is applied to portfolio construction. In an out-of-sample empirical study, we find that the marginal utility gains of the optimal portfolio of a generalized disappointment aversion investor are remarkably robust to misspecifications in the marginal distributions but are very sensitive to the structural assumption of stock returns implemented through a factor model. |
| Keywords: | Model risk, utility function, disappointment aversion |
| JEL: | C5 G12 |
| Date: | 2018–07 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp1865&r=all |
| By: | Thomas Douenne (Paris School of Economics) |
| Abstract: | This paper studies the role of preferences on the link between disasters and growth. An endogenous growth model with disasters is presented in which one can derive closed-form solutions with non-expected utility. The model distinguishes disaster risks and disaster strikes and highlights the numerous mechanisms through which they may affect growth. It is shown that separating aversion to risk from the elasticity of inter-temporal substitution bears critical qualitative implications that enable to better understand these mechanisms. In a calibration of the model, it is shown that for standard parameter values, the additional restriction imposed by the time-additive expected utility can also lead to substantial quantitative bias regarding optimal risk-mitigation policies and growth. The paper thus calls for a wider use of non-expected utility in the modeling of disasters, in particular with respect to environmental disasters and climate change. |
| Keywords: | Environmental disasters, Endogenous growth, Recursive utility, Precautionary savings |
| JEL: | E21 O4 Q54 |
| Date: | 2019–02 |
| URL: | http://d.repec.org/n?u=RePEc:fae:wpaper:2019.05&r=all |
| By: | Matteo Brachetta; Claudia Ceci |
| Abstract: | We study the optimal excess-of-loss reinsurance problem when both the intensity of the claims arrival process and the claim size distribution are influenced by an exogenous stochastic factor. We assume that the insurer's surplus is governed by a marked point process with dual-predictable projection affected by an environmental factor and that the insurance company can borrow and invest money at a constant real-valued risk-free interest rate $r$. Our model allows for stochastic risk premia, which take into account risk fluctuations. Using stochastic control theory based on the Hamilton-Jacobi-Bellman equation, we analyze the optimal reinsurance strategy under the criterion of maximizing the expected exponential utility of the terminal wealth. A verification theorem for the value function in terms of classical solutions of a backward partial differential equation is provided. Finally, some numerical results are discussed. |
| Date: | 2019–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1904.05422&r=all |
| By: | Olkhov, Victor |
| Abstract: | This paper develops economic theory framework free from assumptions on market equilibrium, utility functions, rational expectations and etc. We describe macroeconomics as system of economic agents under action of n risks. Economic and financial variables of agents, their expectations and transactions between agents define macroeconomic variables. Agents variables depend on transactions between agents and transactions are performed under agents expectations. Agents expectations are formed by economic variables, transactions, expectations of other agents, by all factors that impact macroeconomic evolution. We describe evolution of macroeconomic variables, transactions and expectations by systems of economic partial differential equations. We develop asset pricing model as a result of equations on transactions and expectations and derive equations that describe price dynamics. To do this we use risk ratings of economic agents as their coordinates on economic space. We approximate description of economic and financial variables, transactions and expectations of numerous separate agents by description of variables, transactions and expectations as density functions on economic space. We take into account flows of economic variables, transactions and expectations induced by motion of separate agents on economic space due to change of agents risk ratings and describe macroeconomic impact of these economic flows. We apply our model to description of business cycles, describe models of wave propagation for disturbances of economic variables and transactions, model asset price fluctuations and argue hidden complexities of classical Black-Scholes-Merton option pricing. |
| Keywords: | Economic Theory, Risk Ratings, Economic Space, Economic Flows, Density Functions |
| JEL: | C02 E00 E30 E32 G0 G12 |
| Date: | 2019–03–30 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:93085&r=all |
| By: | Regina Hammerschmid (University of Zurich; Swiss Finance Institute); Alexandra Janssen (University of Zurich - Department of Banking and Finance) |
| Abstract: | Currency carry trade returns are on average large and non-normally distributed. While the literature has found different explanations for the existence of carry trade returns, the higher order moments of their return distribution still pose a puzzle. We propose a new model to explain these non-normal properties of currency carry trade returns, by assuming that agents are loss averse and overweight states with low probabilities. This combination of loss aversion and probability weighting is called crash-o-phobia. Using non-linear least squares and risk-neutral state prices implied by currency options, we estimate this crash-o-phobia model to price developed and emerging market currencies. The parameter estimates reveal crash-o-phobic beliefs and preferences with significant differences across currencies. Compared to a model with rational beliefs and CRRA utility, our crash-o-phobia model performs significantly better at explaining the whole distribution of currency carry trade returns. |
| Keywords: | currency carry trade returns, loss aversion, belief estimation, probability distortion, crash-o-phobia |
| JEL: | G11 G12 |
| Date: | 2018–10 |
| URL: | http://d.repec.org/n?u=RePEc:chf:rpseri:rp1864&r=all |
| By: | Giuseppe Attanasi (Université Côte d'Azur, CNRS, GREDEG, France); Kene Boun My (BETA, Université de Strasbourg); Nikolaos Georgantzís (Burgundy School of Business & Economics Department, Universitat Jaume I); Miguel Ginés (Economics Department, Universitat Jaume I) |
| Abstract: | In a two-stage investment-effort game, we model altruistic investment in another agent's capacity to benefit from synergies between the two agents' efforts. Contrary to most models in the literature on altruism, we assume that agents who invest in others have no direct utility from their giving behavior, ruling out any genuinely altruistic component in their utility function, i.e., stemming from other-regarding preferences. Furthermore, we disentangle this strategic ethics" from reputational e ects yielding incentives for a more pro-social action in the present in order to favor Pareto-superior outcomes in the future. Isolated consumption of one's own bene ts from own efforts is the worst equilibrium, which is globally stable and is shown to exist independently of the investment cost. However, for a low enough investment cost, there exist two alternative equilibria: an unstable intermediate equilibrium in which both agents make positive complementarity-building investments, and a stable one in which both agents invest all they can to complementarity building. Both equilibria Pareto-dominate the aforementioned no-investment equilibrium. Results of a laboratory experiment con rm our behavioral prediction that, for a low enough investment cost, subjects coordinate on positive complementarity-building investment, which in turn boosts their effort in the second stage. The latter increases in both own and others' complementarity-building investment, as predicted by our model. All this holds independently of subjects' risk and inequity aversion. The latter suggests that complementarity-building investment is not motivated by altruism. Rather, it is purely strategic. |
| Keywords: | Complementarity-building Investment, Strategic Complementarities, Altruism, Fairness, Risk Aversion |
| JEL: | C72 C73 C91 D64 |
| Date: | 2019–04 |
| URL: | http://d.repec.org/n?u=RePEc:gre:wpaper:2019-13&r=all |
| By: | Senda Ounaies (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Jean-Marc Bonnisseau (CES - Centre d'économie de la Sorbonne - UP1 - Université Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique); Souhail Chebbi (LEGI - Laboratoire d'Économie et de Gestion Industrielle [Tunis] - Ecole Polytechnique de Tunisie) |
| Abstract: | In this paper, we consider a production economy with an unbounded attainable set where the consumers may have non-complete non-transitive preferences. To get the existence of an equilibrium, we provide an asymptotic property on preferences for the attainable consumptions and we use a combination of the nonlinear optimization and fixed point theorems on truncated economies together with an asymptotic argument. We show that this condition holds true if the set of attainable allocations is compact or, when the preferences are representable by utility functions, if the set of attainable individually rational utility levels is compact. This assumption generalizes the CPP condition of [N. Allouch, An equilibrium existence result with short selling, J. Math. Econom. 37 2002, 2, 81–94] and covers the example of [F. H. Page, Jr., M. H. Wooders and P. K. Monteiro, Inconsequential arbitrage, J. Math. Econom. 34 2000, 4, 439–469] when the attainable utility levels set is not compact. So we extend the previous existence results with non-compact attainable sets in two ways by adding a production sector and considering general preferences. |
| Keywords: | nonlinear optimization,quasi-equilibrium,non-compact attainable allocations,Production economy |
| Date: | 2019–03–01 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-01859163&r=all |
| By: | Harashima, Taiji |
| Abstract: | In this paper, I focus on the concept of Nash equilibrium of a Pareto inefficient path (NEPIP) to examine the nature of the transition path to steady state after a shock that generates a severe recession. Risk-averse and non-cooperative households strategically and rationally choose a NEPIP if a shock that widely shifts the steady state downwards occurs. Because NEPIPs are not Pareto efficient, an infinite number of transition paths can be NEPIPs, but a unique NEPIP is eventually selected from among many possible NEPIPs by households through a tug of war between their preference to avoid a worst-case scenario and the expected utility. |
| Keywords: | Great Depression; Great Recession; Pareto inefficiency; Recession; Transition path |
| JEL: | D10 E21 E32 |
| Date: | 2019–04–10 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:93216&r=all |
| By: | Kerr, Geoffrey N. |
| Abstract: | Empirical evidence suggests that Gossen’s law of decreasing marginal utility does not always apply in cultural, hobby and recreational contexts. This can have significant implications for efficient resource allocation. In the presence of increasing marginal utility, benefits are maximised by concentrating resource access in a small number of individuals, rather than widely distributing access. Satisfaction ratings from a panel of 698 hunters who undertook 2,917 red deer hunts provide a test of Gossen’s law with respect to number of deer killed. Latent class ordered logit models outperformed random parameters models and provided evidence of weak non-decreasing marginal utility for all classes of hunter. Study results are applied to test potential efficiency gains from imposing a one red deer per hunt bag limit. |
| Keywords: | Environmental Economics and Policy |
| Date: | 2018–08–31 |
| URL: | http://d.repec.org/n?u=RePEc:ags:nzar18:287272&r=all |
| By: | Prateek Bansal; Rico Krueger; Michel Bierlaire; Ricardo A. Daziano; Taha H. Rashidi |
| Abstract: | Variational Bayes (VB) methods have emerged as a fast and computationally-efficient alternative to Markov chain Monte Carlo (MCMC) methods for Bayesian estimation of mixed multinomial logit (MMNL) models. It has been established that VB is substantially faster than MCMC at practically no compromises in predictive accuracy. In this paper, we address two critical gaps concerning the usage and understanding of VB for MMNL. First, extant VB methods are limited to utility specifications involving only individual-specific taste parameters. Second, the finite-sample properties of VB estimators and the relative performance of VB, MCMC and maximum simulated likelihood estimation (MSLE) are not known. To address the former, this study extends several VB methods for MMNL to admit utility specifications including both fixed and random utility parameters. To address the latter, we conduct an extensive simulation-based evaluation to benchmark the extended VB methods against MCMC and MSLE in terms of estimation times, parameter recovery and predictive accuracy. The results suggest that all VB variants perform as well as MCMC and MSLE at prediction and recovery of all model parameters with the exception of the covariance matrix of the multivariate normal mixing distribution. In particular, VB with nonconjugate variational message passing and the delta-method (VB-NCVMP-Delta) is relatively accurate and up to 15 times faster than MCMC and MSLE. On the whole, VB-NCVMP-Delta is most suitable for applications in which fast predictions are paramount, while MCMC should be preferred in applications in which accurate inferences are most important. |
| Date: | 2019–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1904.03647&r=all |
| By: | Morone, Andrea; Caferra, Rocco |
| Abstract: | In this paper we investigated group size impact on social risk aversion when a majority rule is applied. We used the well-known Holt and Laury's (2002) mechanism to elicit individuals and social risk attitudes. We observed a risk shift in small group and a vanishing of such effect as group size increase. |
| Keywords: | Preferences; Group; Risk Attitude; Majority Rule; Laboratory |
| JEL: | C9 |
| Date: | 2019–03–19 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:92856&r=all |
| By: | Yoshio Kamijo (School of Economics and Management, Kochi University of Technology); Teruyuki Tamura (Department of Management, Kyoto College of Economics) |
| Abstract: | This study examines whether attitudes toward risk and altruism are affected by being in a group or being alone. Differing from previous economic studies of group decision-making, we attempt to exclude the effects of group informal discussion, which are thought to be a black box when individuals make decisions in a group. Subjects in our experiment were requested only to show their faces to other members without any further communication. Moreover, we adopted two collective decision rules—namely, the median rule and the random rule—which provide the truth-telling mechanism. In experiments of both anonymous investments and donations, we found that subjects who made decisions in a group offered significantly lower amounts than individuals who made decisions alone, even controlling for individuals’ risk and altruistic preferences. Our results indicate that people are more risk averse and self-interested when they are in a group regardless of which collective decision rules are adopted. |
| Keywords: | Group decision, Individual decision, Altruism, Decision under risk |
| JEL: | C91 C92 D81 |
| Date: | 2019–04 |
| URL: | http://d.repec.org/n?u=RePEc:kch:wpaper:sdes-2019-3&r=all |