
on Utility Models and Prospect Theory 
Issue of 2019‒09‒30
twentyone papers chosen by Alexander Harin Modern University for the Humanities 
By:  Donald J. Brown (Dept. of Economics, Yale University) 
Abstract:  Ambiguous assets are characterized as assets where objective and subjective probabilities of tomorrowâ€™s assetreturns are illdeï¬ ned or may not exist, e.g., bitcoin, volatility indices or any IPO. Investors may choose to diversify their portfolios of ï¬ at money, stocks and bonds by investing in ambiguous assets, a fourth asset class, to hedge the uncertainties of future returns that are not risks. (IR)rational probabilities are computable alternative descriptions of the distribution of returns for ambiguous assets. (IR)rational probabilities can be used to deï¬ ne an investorâ€™s (IR)rational expected utility function in the class of nonexpected utilities. Investment advisors use revealed preference analysis to elicit the investorâ€™s composite preferences for risk tolerance, ambiguity aversion and optimism. Investors rationalize (IR)rational expected utilities over portfolios of ï¬ at money, stocks, bonds and ambiguous assets by choosing their optimal portfolio investments with (IR)rational expected utilities. Subsequently, investors can hedge future losses of their optimal portfolios by purchasing minimumcost portfolio insurance. 
Keywords:  Behavioral Finance, Prospect Theory, Afriat Inequalities 
JEL:  B31 C91 D9 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:cwl:cwldpp:2202&r=all 
By:  Bouchra Benyelles (DRM  Dauphine Recherches en Management  Université ParisDauphine  CNRS  Centre National de la Recherche Scientifique); Eser Arisoy (DRM  Dauphine Recherches en Management  Université ParisDauphine  CNRS  Centre National de la Recherche Scientifique) 
Abstract:  We investigate whether regret can explain mutual fund managers' riskshifting behavior. We propose a theoretical framework by introducing a modi_ed utility function for mutual fund managers who are both risk averse and regret averse. The empirical tests of the proposed framework imply that mutual fund managers who perform worse than their peers (i.e., who exhibit returnregret) tend to have a positive riskshifting, whereas those who have a higher portfolio volatility (i.e., who exhibit varianceregret) tend to have a negative riskshifting behavior over the next period. Furthermore, we document that the e_ect of variance regret is more signi_cant for institutional funds than for retail funds. Finally, when considering fund ows, the returnregret e_ect is more signifcant than the varianceregret e_ect, conrming that investors' outows are mainly due fund managers' bad performance relative to their peers. The results are robust to using alternative measures of regret based on funds' potential benchmarks. 
Keywords:  Regret theory,Mutual Funds,Risk shifting. 
Date:  2019–06 
URL:  http://d.repec.org/n?u=RePEc:hal:journl:hal02283993&r=all 
By:  Bouchra Benyelles (DRM  Dauphine Recherches en Management  Université ParisDauphine  CNRS  Centre National de la Recherche Scientifique); Eser Arisoy (DRM  Dauphine Recherches en Management  Université ParisDauphine  CNRS  Centre National de la Recherche Scientifique) 
Abstract:  We investigate whether regret can explain mutual fund managers' riskshifting behavior. We propose a theoretical framework by introducing a modi_ed utility function for mutual fund managers who are both risk averse and regret averse. The empirical tests of the proposed framework imply that mutual fund managers who perform worse than their peers (i.e., who exhibit returnregret) tend to have a positive riskshifting, whereas those who have a higher portfolio volatility (i.e., who exhibit varianceregret) tend to have a negative riskshifting behavior over the next period. Furthermore, we document that the e_ect of variance regret is more signi_cant for institutional funds than for retail funds. Finally, when considering fund ows, the returnregret e_ect is more signifcant than the varianceregret e_ect, conrming that investors' outows are mainly due fund managers' bad performance relative to their peers. The results are robust to using alternative measures of regret based on funds' potential benchmarks. 
Keywords:  Regret theory,Mutual Funds,Risk shifting 
Date:  2019–07 
URL:  http://d.repec.org/n?u=RePEc:hal:journl:hal02283899&r=all 
By:  HaHuy, Thai 
Abstract:  The famous theorem of Savage is based on the richness of the states space, by assuming a continuum nature for this set. In order to fill the gap, this article considers Savage's theorem with discrete state space. The article points out the importance the existence of pair event in the existence of utility function and the subjective probability. Under the discrete states space, this can be ensured by the intuitive atom swarming condition. Applications for the establishment of an intertemporal evaluation a la Koopman, and for the configuration under unlikely atoms of Mackenzie Mackenzie2018 are provided. 
Keywords:  Savage theorem, Koopman representation, expected utility function, atom swarming. 
JEL:  C00 D10 D90 
Date:  2019–06–16 
URL:  http://d.repec.org/n?u=RePEc:pra:mprapa:96108&r=all 
By:  Shenhao Wang; Jinhua Zhao 
Abstract:  Whereas deep neural network (DNN) is increasingly applied to choice analysis, it is challenging to reconcile domainspecific behavioral knowledge with genericpurpose DNN, to improve DNN's interpretability and predictive power, and to identify effective regularization methods for specific tasks. This study designs a particular DNN architecture with alternativespecific utility functions (ASUDNN) by using prior behavioral knowledge. Unlike a fully connected DNN (FDNN), which computes the utility value of an alternative k by using the attributes of all the alternatives, ASUDNN computes it by using only k's own attributes. Theoretically, ASUDNN can dramatically reduce the estimation error of FDNN because of its lighter architecture and sparser connectivity. Empirically, ASUDNN has 23% higher prediction accuracy than FDNN over the whole hyperparameter space in a private dataset that we collected in Singapore and a public dataset in R mlogit package. The alternativespecific connectivity constraint, as a domainknowledgebased regularization method, is more effective than the most popular genericpurpose explicit and implicit regularization methods and architectural hyperparameters. ASUDNN is also more interpretable because it provides a more regular substitution pattern of travel mode choices than FDNN does. The comparison between ASUDNN and FDNN can also aid in testing the behavioral knowledge. Our results reveal that individuals are more likely to compute utility by using an alternative's own attributes, supporting the longstanding practice in choice modeling. Overall, this study demonstrates that prior behavioral knowledge could be used to guide the architecture design of DNN, to function as an effective domainknowledgebased regularization method, and to improve both the interpretability and predictive power of DNN in choice analysis. 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1909.07481&r=all 
By:  Nikolov, Plamen (State University of New York) 
Abstract:  Attitudes toward risk underlie virtually every important economic decision an individual makes. In this experimental study, I examine how introducing a time delay into the execution of an investment plan influences individuals' risk preferences. The field experiment proceeded in three stages: a decision stage, an execution stage and a payout stage. At the outset, in the Decision Stage (Stage 1), each subject was asked to make an investment plan by splitting a monetary investment amount between a risky asset and a safe asset. Subjects were informed that the investment plans they made in the Decision Stage are binding and will be executed during the Execution Stage (Stage 2). The Payout Stage (Stage 3) was the payout date. The timing of the Decision Stage and Payout Stage was the same for each subject, but the timing of the Execution Stage varied experimentally. I find that individuals who were assigned to execute their investment plans later (i.e., for whom there was a greater delay prior to the Execution Stage) invested a greater amount in the risky asset during the Decision Stage. 
Keywords:  risk and time, risk preferences, referencedependent utility preferences, temporal construal, time inconsistency, endowment effect, field experiment 
JEL:  D03 D81 D91 O12 O16 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:iza:izadps:dp12626&r=all 
By:  Kaas, R; Goovaerts, M 
Abstract:  The mathematical concept of stochastic dominance was introduced to describe preference of one random gain over another. We show that for bounded gains apart from the mathematical definition there is a more natural interpretation: one gain dominates another if the expected values of a class of nondecreasing functions are larger. This class of functions includes all natural utility functions. Some special choices give the necessary conditions for stochastic dominance derived by W.H. Jean (1980, 1984). We also provide some easy to check sufficient conditions for stochastic dominance. It is argued that if the difference of the densities of two gains has n1 sign changes and certain moment relations are satisfied, one dominates the other stochastically for order n . 
Keywords:  Research Methods/ Statistical Methods 
Date:  2019–09–26 
URL:  http://d.repec.org/n?u=RePEc:ags:amstas:293089&r=all 
By:  Ricardo Sabbadini 
Abstract:  Empirical evidence indicates that a decline in international riskfree interest rates decreases emerging markets (EM) sovereign spreads. A standard quantitative model of sovereign default, calibrated to match average levels of debt and spread, does not replicate this feature even if the risk aversion of lenders moves with international interest rates. In this paper, I show that a model with lenders that are lossaverse and have reference dependence, traits suggested by the behavioral finance literature, replicates the noticed stylized fact. In this framework, when international interest rates fall, EM sovereign spreads decline despite increases in debt and default risk. This happens because investors search for yield in risky EM bonds when the riskfree rate is lower than their return of reference. I find that larger spread reductions occur for i) riskier countries; ii) greater declines in the riskfree rate; and iii) higher degrees of loss aversion. 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:bcb:wpaper:500&r=all 
By:  Sushant Acharya; Edouard Challe (CREST & Ecole Polytechnique); Keshav Dogra (Federal Reserve Bank of New York) 
Abstract:  In this paper, we study the positive and normative implications for monetary policy of crosssectional wealth dispersion due to uninsured, idiosyncratic laborincome risk. To this purpose we develop a tractable HeterogenousAgent New Keynesian (HANK) model based on CARA (Constant Absolute Risk Aversion) utility functions and Normally distributed laborincome risk. The distributions of wealth, earnings and consumptions, as well as their dynamics over time, can be solved in closed form, which informs us about the precise impact of monetary policy on those crosssectional distributions. The Social Welfare Function (SWF) that aggregates agents utility can also be solved in closed form. Besides its usual determinants, the optimal policy response to aggregate shocks gives a central role to (i) the redistribution of wealth through inflation (as emphasized by Bhandari et al., 2018), and (ii) the impact of policy on the marginal propensity to consume out of wealth, which determines the passthrough from income risk to consumption risk 
Date:  2019 
URL:  http://d.repec.org/n?u=RePEc:red:sed019:381&r=all 
By:  Bouchra Benyelles (DRM  Dauphine Recherches en Management  Université ParisDauphine  CNRS  Centre National de la Recherche Scientifique); Eser Arisoy (DRM  Dauphine Recherches en Management  Université ParisDauphine  CNRS  Centre National de la Recherche Scientifique) 
Abstract:  We investigate whether regret can explain mutual fund managers' riskshifting behavior. We propose a theoretical framework by introducing a modified utility functionfor mutual fund managers who are both risk averse and regret averse. The empiricaltests of the proposed framework imply that mutual fund managers who perform worsethan their peers (i.e., who exhibit returnregret) tend to have a positive riskshifting,whereas those who have a higher portfolio volatility (i.e., who exhibit varianceregret)tend to have a negative riskshifting behavior over the next period. Furthermore, wedocument that the effect of variance regret is more significant for institutional fundsthan for retail funds. Finally, when considering fund flows, the returnregret effect ismore significant than the varianceregret effect, confirming that investors' outflows aremainly due fund managers' bad performance relative to their peers. The results arerobust to using alternative measures of regret based on funds' potential benchmarks. 
Keywords:  Regret theory,Mutual Funds,Risk shifting 
Date:  2018–10 
URL:  http://d.repec.org/n?u=RePEc:hal:journl:hal02283886&r=all 
By:  Guangyu PEI (The Chinese University of Hong Kong) 
Abstract:  This paper develops a novel theory of uncertaintydriven business cycles that accommodates the notion of noninflationary aggregate demand shocks out of variations in uncertainty. Instead of thinking uncertainty as risk, we regard uncertainty as ambiguity. We demonstrate that within the real business cycle model, ambiguity shocks, namely shock to the variance of agents' prior belief over possible models, can generate comovements across real quantities without commensurate movements in labor productivity under the condition that agents are ambiguity averse and there exists a certain type of coordination friction among them. In response to a positive ambiguity, agents behave as if they believe aggregate demand is turning bad and becoming more volatile. The former translates into depressed market confidence, which makes all real quantities plummets. While the latter incentivizes agents use more of their private information both when making economic decisions and forecasts, which heightens the crosssectional dispersions of beliefs. These predictions regarding agents' belief in our theory are consistent with survey data evidence. Finally, the quantitative potential of our theory is illustrated within a dynamic RBC model. 
Date:  2019 
URL:  http://d.repec.org/n?u=RePEc:red:sed019:1494&r=all 
By:  Lei Fang (Federal Reserve Bank of Atlanta); Anne Hannusch (University of Mannheim); Pedro Silos (Temple University) 
Abstract:  Households combine market goods and their time to produce different types of consumption activities, from which they derive utility. This paper documents that households with more education allocate more time and a higher share of expenditure to expenditureintensive leisure activities, such as entertainment; while households with less education allocate more time on time intensive leisure activities, such as watching TV. Employing the difference in the allocation of time and expenditures, this paper estimates a utility function with different substitutability between time and expenditure across consumption activities. Compared with a standard utility function in which time generates utility only through the form of leisure, the proposed utility function exhibits a larger response in labor supply and a smaller response in welfare inequality to wage and price changes. 
Date:  2019 
URL:  http://d.repec.org/n?u=RePEc:red:sed019:1386&r=all 
By:  Christian R. Proaño; Benjamin Lojak 
Abstract:  In this paper we investigate the riskrelated effects of monetary policy in normal times, as well as in periods where the zero lower bound (ZLB) binds, in a stylized macroeconomic model with boundedly rational beliefs. In our model, financial market participants use heuristics to assess the risk premium over the policy rate in accordance to an “implicit Taylor rule” that measures the stance of conventional monetary policy and which serves as an informative instrument during times when the funds rate is constrained by the ZLB. In such a case, conventional monetary policy is exhausted so that the central bank is forced to use unconventional types of policy. We propose alternative monetary policy measures to help the economy out of the liquidity trap which take into account this assumed form of bounded rationality. 
Keywords:  Behavioral Macroeconomics, Monetary Policy, Zero Lower Bound, Bounded Rationality 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:een:camaaa:201973&r=all 
By:  Katia Colaneri; Stefano Herzel; Marco Nicolosi 
Abstract:  This paper presents an optimal allocation problem in a financial market with one riskfree and one risky asset, when the market is driven by a stochastic market price of risk. We solve the problem in continuous time, for an investor with a Constant Relative Risk Aversion (CRRA) utility, under two scenarios: when the market price of risk is observable (the {\em full information case}), and when it is not (the {\em partial information case}). The corresponding market models are complete in the partial information case and incomplete in the other case, hence the two scenarios exhibit rather different features. We study how the access to more accurate information on the market price of risk affects the optimal strategies and we determine the maximal price that the investor would be willing to pay to get such information. In particular, we examine two cases of additional information, when an exact observation of the market price of risk is available either at time $0$ only (the {\em initial information case}), or during the whole investment period (the {\em dynamic information case}). 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1909.07837&r=all 
By:  Michael Woodford 
Abstract:  Traditional decision theory assumes that people respond to the exact features of the options available to them, but observed behavior seems much less precise. This review considers ways of introducing imprecision into models of economic decision making, and stresses the usefulness of analogies with the way that imprecise perceptual judgments are modeled in psychophysics — the branch of experimental psychology concerned with the quantitative relationship between objective features of an observer's environment and elicited reports about their subjective appearance. It reviews key ideas from psychophysics, provides examples of the kinds of data that motivate them, and proposes lessons for economic modeling. Applications include stochastic choice, choice under risk, decoy effects in marketing, global game models of strategic interaction, and delayed adjustment of prices in response to monetary disturbances. 
JEL:  C25 C91 D81 D91 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:nbr:nberwo:26258&r=all 
By:  Mihir Bhattacharya (Department of Economics, Ashoka University); Saptarshi Mukherjee (Department of Humanities and Social Sciences, IIT Delhi); Ruhi Sonal (Department of Humanities and Social Sciences, IIT Delhi) 
Abstract:  We consider individual decisionmaking where every alternative appears with a frame (a la Salant and Rubinstein (2008)). The decision maker is subject to inattention due to framing effects that leads to random choice. We characterize a framebased stochastic choice rule according to which the choice probability of an alternative (say, x) is the probability with which attention is drawn by its frame and not by the frames which are associated with the alternatives that beat x according to a complete binary relation. 
Keywords:  attention, framing, stochastic choice 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:ash:wpaper:1027&r=all 
By:  Fabien Perez (ENSAE  Ecole Nationale de la Statistique et de l'Analyse Economique  Ecole Nationale de la Statistique et de l'Analyse Economique); Guillaume Hollard (CES  Centre d'économie de la Sorbonne  UP1  Université PanthéonSorbonne  CNRS  Centre National de la Recherche Scientifique); Radu Vranceanu (THEMA  Théorie économique, modélisation et applications  UCP  Université de Cergy Pontoise  Université ParisSeine  CNRS  Centre National de la Recherche Scientifique); Delphine Dubart (ESSEC Business School  Essec Business School) 
Abstract:  This paper uses the test/retest data from the Holt and Laury (2002) experiment to provide estimates of the measurement error in this popular riskaversion task. Maximum likelihood estimation suggests that the variance of the measurement error is approximately equal to the variance of the number of safe choices. Simulations confirm that the coefficient on the risk measure in univariate OLS regressions is approximately half of its true value. Unlike measurement error, the discrete transformation of continuous riskaversion is not a major issue. We discuss the merits of a number of different solutions: increasing the number of observations, IV and the ORIV method developed by Gillen et al. (2019). 
Keywords:  ORIV,Experiments,Measurement error,Riskaversion,Test/retest 
Date:  2019–09–17 
URL:  http://d.repec.org/n?u=RePEc:hal:cesptp:hal02291224&r=all 
By:  Lorenzo Bretscher (London Business School); Alex Hsu (Georgia Institute of Technology); Andrea Tamoni (London School of Economics) 
Abstract:  Uncertainty shocks are also risk premium shocks. With countercyclical risk aversion (RA), a positive shock to uncertainty not only increases risk, but it also elevates RA as consumption growth falls. The combination of high RA and high uncertainty produces significant risk premia in bad times, which in turn exacerbate the decline of macroeconomic aggregates and equity prices. Empirically, we document that local projection coefficients capturing the data response to the interaction of risk aversion and uncertainty are statistically significant and economically large. Indeed, heightened levels of RA during the 2008 crisis amplified the drop in output and investment by 41% and 28%, respectively, at the recession trough. Theoretically, we show that a NewKeynesian model with endogenously timevarying risk aversion via Campbell and Cochrane (1999) can produce large falls in output and investment close to matching their data counterparts following positive uncertainty shocks. 
Date:  2019 
URL:  http://d.repec.org/n?u=RePEc:red:sed019:1567&r=all 
By:  Hasan Fallahgoul (Monash University); Julien Hugonnier (Swiss Federal Institute of Technology Lausanne  Ecole Polytechnique Fédérale de Lausanne; Swiss Finance Institute); Loriano Mancini (USI Lugano  Institute of Finance; Swiss Finance Institute) 
Abstract:  To study jump and volatility risk premia in asset returns, we develop a novel class of timechanged Lévy models. The models are characterized by flexible Lévy measures, and allow consistent estimation under physical and risk neutral measures. To operationalize the models, we introduce a simple and rigorous filtering procedure to recover the unobservable time changes. An extensive time series and option pricing analysis of 16 timechanged Lévy models shows that infinite activity processes carry significant jump risk premia, and largely outperform many finite activity processes. 
Keywords:  Lévy jumps, time changes, tempered stable law, time series, option pricing 
JEL:  C5 G12 
Date:  2019–02 
URL:  http://d.repec.org/n?u=RePEc:chf:rpseri:rp1949&r=all 
By:  Roland Fuess; Massimo Guidolin; Christian Koeppel 
Abstract:  This paper introduces a new sentimentaugmented asset pricing model in order to provide a comprehensive understanding of the role of nonfundamental risk factors. We find that news and social media searchbased indicators that measure the aggregate investor sentiment are significantly related to excess returns across different asset classes and markets. Adding sentiment factors to both classical and more recent stateoftheart pricing models leads to a significant increase in model performance. Following a twostage FamaMacBeth procedure, our modified pricing model obtains positive estimates of the risk premium for negative sentiment for global equity markets. We interpret them as measures of additional market uncertainty not captured by standard risk factors. Negative sentiment captures investors' fear, for which they demand an additional risk premium on sentimentsensitive assets. Consequently, our empirical results contribute to the explanation of the crosssection of average, international excess equity and foreign exchange returns. 
Keywords:  Sentiment; Crosssection of international equity indices; Currency returns; FamaMacBeth risk premia estimation 
Date:  2019 
URL:  http://d.repec.org/n?u=RePEc:baf:cbafwp:cbafwp19116&r=all 
By:  T. Erber; M. J. Frank 
Abstract:  Arrow's `impossibility' theorem asserts that there are no satisfactory methods of aggregating individual preferences into collective preferences in many complex situations. This result has ramifications in economics, politics, i.e., the theory of voting, and the structure of tournaments. By identifying the objects of choice with mathematical sets, and preferences with Hausdorff measures of the distances between sets, it is possible to extend Arrow's arguments from a sociological to a mathematical setting. One consequence is that notions of reversibility can be expressed in terms of the relative configurations of patterns of sets. 
Date:  2019–09 
URL:  http://d.repec.org/n?u=RePEc:arx:papers:1909.07771&r=all 