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on Utility Models and Prospect Theory |
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Issue of 2020‒06‒29
23 papers chosen by |
| By: | Quitz\'e Valenzuela-Stookey |
| Abstract: | Complexity of the problem of choosing among uncertain acts is a salient feature of many of the environments in which departures from expected utility theory are observed. I propose and axiomatize a model of choice under uncertainty in which the size of the partition with respect to which an act is measurable arises endogenously as a measure of subjective complexity. I derive a representation of incomplete Simple Bounds preferences in which acts that are complex from the perspective of the decision maker are bracketed by simple acts to which they are related by statewise dominance. The key axioms are motivated by a model of learning from limited data. I then consider choice behavior characterized by a "cautious completion" of Simple Bounds preferences, and discuss the relationship between this model and models of ambiguity aversion. I develop general comparative statics techniques, and explore applications to portfolio choice, contracting, and insurance choice. |
| Date: | 2020–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2006.01852&r=all |
| By: | de Groot, Oliver; Richter, Alexander; Throckmorton, Nathaniel |
| Abstract: | This paper shows the success of valuation risk-time-preference shocks in Epstein-Zin utility-in resolving asset pricing puzzles rests sensitively on the way it is introduced. The specification used in the literature violates several desirable properties of recursive preferences because the weights in the Epstein-Zin time-aggregator do not sum to one. When we revise the specification in a simple asset pricing model the puzzles resurface. However, when estimating a sequence of increasingly rich models, we find valuation risk under the revised specification consistently improves the ability of the models to match asset price and cash-flow dynamics. |
| Keywords: | Asset Pricing; Equity premium puzzle; recursive utility; Risk-Free Rate Puzzle |
| JEL: | C15 D81 G12 |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:14588&r=all |
| By: | Géraldine Bocqueho (BETA - Bureau d'Économie Théorique et Appliquée - INRA - Institut National de la Recherche Agronomique - CNRS - Centre National de la Recherche Scientifique - UL - Université de Lorraine - UNISTRA - Université de Strasbourg); Marc Deschamps (UBFC - Université Bourgogne Franche-Comté [COMUE]); Jenny Helstroffer (UL - Université de Lorraine); Julien Jacob (UL - Université de Lorraine); Majlinda Joxhe (Uni.lu - Université du Luxembourg) |
| Abstract: | This paper uses the experimental setup of Tanaka et al. (2010) to measure refugees' risk preferences. A sample of 206 asylum seekers was interviewed in 2017-18 in Luxembourg. Contrary to studies which focus on risk aversion in gen- eral, we analyze its components using a cumulative prospect theory (CPT) frame- work. We show that refugees exhibit particularly low levels of risk aversion com- pared to other populations and that CPT provides a better fit for modelling risk at- titudes. Moreover, we include randomised temporary treatments provoking emo- tions and find a small significant impact on probability distortion. Robustness of the Tanaka et al. (2010) experimental framework is confirmed by including treat- ments regarding the embedding effect. Finally, we propose a theoretical model of refugee migration that integrates the insights from our experimental outcomes regarding the functional form of refugees' decision under risk and the estimated parameter values. The model is then simulated using the data from our study. |
| Keywords: | refugee migration,risk preferences,cumulative prospect theory,psychological priming,experimental economics |
| Date: | 2020–06–05 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-02788767&r=all |
| By: | Philippe Le Coent (CEE-M - Centre d'Economie de l'Environnement - Montpellier - FRE2010 - INRA - Institut National de la Recherche Agronomique - UM - Université de Montpellier - CNRS - Centre National de la Recherche Scientifique - Montpellier SupAgro - Institut national d’études supérieures agronomiques de Montpellier); Raphaële Préget (CEE-M - Centre d'Economie de l'Environnement - Montpellier - FRE2010 - INRA - Institut National de la Recherche Agronomique - UM - Université de Montpellier - CNRS - Centre National de la Recherche Scientifique - Montpellier SupAgro - Institut national d’études supérieures agronomiques de Montpellier); Sophie Thoyer (CEE-M - Centre d'Economie de l'Environnement - Montpellier - FRE2010 - INRA - Institut National de la Recherche Agronomique - UM - Université de Montpellier - CNRS - Centre National de la Recherche Scientifique - Montpellier SupAgro - Institut national d’études supérieures agronomiques de Montpellier, Montpellier SupAgro - Institut national d’études supérieures agronomiques de Montpellier) |
| Abstract: | This article analyses the role played by social norms in farmers' decisions to enroll into an agri-environmental scheme (AES). First, it develops a simple theoretical model highlighting the interplay of descriptive and injunctive norms in farmers' utility functions. Second, an empirical valuation of the effect of social norms is provided based on the results of a stated preference survey conducted with 98 wine-growers in the South of France. Proxies are proposed to capture and measure the weight of social norms in farmers' decision to sign an agri-environmental contract. Our empirical results indicate that the injunctive norm seems to play a stronger role than the descriptive norm. |
| Keywords: | social norms,behaviour,agri-environmental contracts |
| Date: | 2020–06–05 |
| URL: | http://d.repec.org/n?u=RePEc:hal:wpaper:hal-02791014&r=all |
| By: | Juan Li; Wenqiang Li; Gechun Liang |
| Abstract: | This paper studies an optimal forward investment problem in an incomplete market with model uncertainty, in which the dynamics of the underlying stocks depends on the correlated stochastic factors. The uncertainty stems from the probability measure chosen by an investor to evaluate the performance. We obtain directly the representation of the power robust forward performance process in factor-form by combining the zero-sum stochastic differential game and ergodic BSDE approach. We also establish the connections with the risk-sensitive zero-sum stochastic differential games over an infinite horizon with ergodic payoff criteria, as well as with the classical power robust expected utility for long time horizons. |
| Date: | 2020–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2005.10660&r=all |
| By: | Begho, Toritseju |
| Abstract: | The paper examines the relationship between off-farm work decisions and risk and uncertainty attitudes. Data was obtained from controlled lab-in-field experiment on farmers’ choices over pairs of continuous prospects. The paper estimated parametric functional forms of the value and weighting functions based on cumulative prospect theory and examined the effect on important off-farm work decisions. The paper find evidence that farmers that participated in off-farm jobs were more averse to losses under conditions of risk but not so for uncertainty. However, these categories of farmers were more pessimistic about losses under both conditions (i.e. risk and uncertainty). The results also show that risk and uncertainty aversion significantly differ between farmers that participated in paid versus self-employed off-farm jobs. The result also shows that age, farm size, tenure, location, membership of association, location are significant determinants off-farm work decisions. |
| Keywords: | Farm Management, Risk and Uncertainty |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:ags:aesc20:303708&r=all |
| By: | Ying Hu; Hanqing Jin; Xun Yu Zhou |
| Abstract: | We study portfolio selection in a complete continuous-time market where the preference is dictated by the rank-dependent utility. As such a model is inherently time inconsistent due to the underlying probability weighting, we study the investment behavior of sophisticated consistent planners who seek (subgame perfect) intra-personal equilibrium strategies. We provide sufficient conditions under which an equilibrium strategy is a replicating portfolio of a final wealth. We derive this final wealth profile explicitly, which turns out to be in the same form as in the classical Merton model with the market price of risk process properly scaled by a deterministic function in time. We present this scaling function explicitly through the solution to a highly nonlinear and singular ordinary differential equation, whose existence of solutions is established. Finally, we give a necessary and sufficient condition for the scaling function to be smaller than 1 corresponding to an effective reduction in risk premium due to probability weighting. |
| Date: | 2020–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2006.01979&r=all |
| By: | Rau, Holger A. |
| Abstract: | This paper analyzes in a within-subjects experiment time preferences when peopledecide for themselves and on behalf of others. The data show that subjects becomemore impatient when making decisions, which affect the payoff of others. Thechange can be explained by altruistic subjects who increase their focus on earlyconsumption when responsible for others' payoffs |
| Keywords: | Decisions fo rOthers,Experiment,Time Preferences |
| JEL: | C91 D14 D81 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:cegedp:395&r=all |
| By: | michel Beine (Department of Economics and Management, Université du Luxembourg); Gary Charness (Department of Economics, University of California, Santa Barbara, USA); Anaud Dupuy (Department of Economics and Management, Université du Luxembourg); Majlinda Joxhe (Department of Economics and Management, Université du Luxembourg) |
| Abstract: | We conduct a survey and incentivized lab-in-the-field experimental tasks in Tirana, Albania. While the original purpose of our study was to examine whether and how deep parameters such as time and risk preferences affect the intention to migrate, our study was transformed into a natural experiment owing to two large earthquakes that shook the Tirana area during our data-collection period. These events provide us with a rare opportunity to gather evidence (including a pre-earthquake control) on the effect of natural disasters on time and risk preferences. We find unambiguous effects towards more risk aversion and impatience for affected individuals. Moreover, as it turns out, the second earthquake amplified the effect of the first one, suggesting that experiences cumulate in their influence on these preferences. |
| Keywords: | Time preferences, risk preferences, natural disaster, Albania, migration |
| JEL: | B49 C90 D91 F22 |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:luc:wpaper:20-09&r=all |
| By: | Robert D. Cairns (Centre Interuniversitaire de Recherche en Economie Quantitative, Université McGill [Montréal]); Stellio del Campo (ECO-PUB - Economie Publique - INRA - Institut National de la Recherche Agronomique - AgroParisTech, EconomiX - CNRS - Centre National de la Recherche Scientifique - UPN - Université Paris Nanterre); Vincent Martinet (ECO-PUB - Economie Publique - INRA - Institut National de la Recherche Agronomique - AgroParisTech) |
| Abstract: | The highest utility level that can be sustained in an economy is given by the maximin value. To be able to use this value for sustainability accounting, the corresponding maximin problem must be solved. This paper studies the sustainability of an economy composed of two reproducible assets, each producing one of two consumption goods which are substitutes in utility. We characterize the maximin path of the economy, and associated maximin shadow values. We discuss how these shadow values could be used as accounting prices for development paths that differ from the maximin trajectory. The corresponding genuine savings indicator informs on the improvement or decline of the sustainable level of utility and the prospects of future generations. |
| Abstract: | Le plus haut niveau d'utilité qui peut être soutenu dans une économie est donné par la valeur du maximin. Pour être en mesure d'utiliser cette valeur dans le cadre d'une comptabilité environnementale, le problème de maximin correspondant doit être résolu. Cet article étudie la soutenabilité d'une économie basée sur deux actifs renouvelables, chacun produisant un des deux biens de consommation qui sont des substituts dans la fonction d'utilité. Nous caractérisons le sentier maximin de cette économie, et les valeurs implicites associées. Nous discutons de la manière d'utiliser ces valeurs implicites comme des prix comptables le long de trajectoires qui diffèrent du sentier maximin. L'indicateur d'épargne véritable correspondant informe sur l'amélioration ou la détérioration du niveau d'utilité soutenable, et donc sur les opportunités offertes aux générations futures. |
| Keywords: | substituability,subtainability accounting,maximin,maximin value,comptabilité environnementale,substituabilité |
| Date: | 2019 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-02623141&r=all |
| By: | Qianqian Zhou; Junyi Guo |
| Abstract: | In this paper, we study the optimal investment problem of an insurer whose surplus process follows the diffusion approximation of the classical Cramer-Lundberg model. Investment in the foreign market is allowed, and therefore, the foreign exchange rate model is considered and incorporated. It is assumed that the instantaneous mean growth rate of foreign exchange rate price follows an Ornstein-Uhlenbeck process. Dynamic programming method is employed to study the problem of maximizing the expected exponential utility of terminal wealth. By soloving the correspoding Hamilton-Jacobi-Bellman equations, the optimal investment strategies and the value functions are obtained. Finally, numerical analysis is presented. |
| Date: | 2020–06 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2006.02857&r=all |
| By: | Bonsoo Koo; Athanasios A. Pantelous; Yunxiao Wang |
| Abstract: | The global shift towards defined-contribution pension schemes has been accompanied by asymmetric risks and new responsibilities for households to plan and fund effectively their own retirement over the years. In this study, expressing and combining preferences for consumption, investment, bequest, public pension entitlement and the choice of reverse mortgage products, we develop several utilitybased life cycle models to facilitate the complex decision-making process that retired households are required to follow to optimise their retirement income. This optimal policy is given in the form of either an analytical or a numerical solution using stochastic dynamic programming. The timing of this paper coincides with the launch of a reverse mortgage style loan, offered by the Australian federal government and allowing retired households to receive an income stream by taking out a loan against the equity in their home. Calibration is performed using real Australian household data. |
| Keywords: | risk management, stochastic optimal control, life cycle models, retirement income, reverse mortgage, defined contribution |
| Date: | 2020 |
| URL: | http://d.repec.org/n?u=RePEc:msh:ebswps:2020-21&r=all |
| By: | Mark Dickie (University of Central Florida); Shelby Gerking (Tilburg University); Wiktor Adamowicz (University of Alberta); Marcella Veronesi (Department of Economics (University of Verona)) |
| Abstract: | The paper investigates the validity of individuals’ perceptions of heart disease risks, and examines how information and risk perceptions affect marginal willingness to pay (MWTP) to reduce risk, using data from a stated preference survey. Results indicate that risk perceptions individuals held before receiving risk information are plausibly related to objective risk factors and reflect individual-specific information not found in aggregate measures of objective risk. After receiving information, individuals’ updates of prior risk assessments are broadly consistent with Bayesian learning. Perceived heart disease risks thus satisfy construct validity and provide a valid basis for inferring MWTP to reduce risk. Estimating MWTP based on objective rather than subjective risks causes misleading inferences about benefits of risk reduction. An empirical case study shows that benefits are 36% to 62% higher when estimated using objective rather than subjective risks, showing the importance of employing risk perception information to improve validity of benefit measures. |
| Keywords: | risk perception, willingness to pay, subjective probability, information, Bayesian, heart disease |
| JEL: | D61 I12 I38 J13 Q51 Q58 |
| Date: | 2020–06 |
| URL: | http://d.repec.org/n?u=RePEc:ver:wpaper:11/2020&r=all |
| By: | Maenhout, Pascal; Vedolin, Andrea; Xing, Hao |
| Abstract: | This paper develops a theory of dynamic pessimism and its impact on asset prices. Notions of time-varying pessimism arise endogenously in our setting as a consequence of agents' concern for model misspecification. We generalize the robust control approach of Hansen and Sargent (2001) by replacing relative entropy as a measure of discrepancy between models by the more general family of Cressie-Read discrepancies. As a consequence, the decision-maker's distorted beliefs appear as an endogenous state variable driving risk aversion, portfolio decisions, and equilibrium asset prices. Using survey data, we estimate time-varying pessimism and find that such a proxy features a strong business cycle component. We then show that using our measure of pessimism helps match salient features in equity markets such as excess volatility and high equity premium. |
| Keywords: | Cressie Read; Pessimism; Robust control; Subjective beliefs |
| JEL: | F31 G15 |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:14592&r=all |
| By: | Kopecky, Joseph V.; Taylor, Alan M. |
| Abstract: | Population aging has been linked to global declines in interest rates. A similar trend shows that equity risk premia are on the rise. An existing literature can explain part of the decline in the trend in safe rates using demographics, but has no mechanism to speak to trends in relative asset prices. We calibrate a heterogeneous agent life-cycle model with equity markets, showing that this demographic channel can simultaneously account for both the majority of a downward trend in the risk free rate, while also increasing premium attached to risky assets. This is because the life cycle savings dynamics that have been well documented exert less pressure on risky assets as older households shift away from risk. Under reasonable calibrations we find declines in the safe rate that are considerably larger than most existing estimates between the years 1990 and 2017. We are also able to account for most of the rise in the equity risk premium. Projecting forward to 2050 we show that persistent demographic forces will continue push the risk free rate further into negative territory, while the equity risk premium remains elevated. |
| Keywords: | demographics; Life-Cycle Model; OLG model; Rates of return; risky assets; safe assets; secular stagnation |
| JEL: | E21 E43 G11 J11 |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:cpr:ceprdp:14576&r=all |
| By: | Belzil, Christian (Ecole Polytechnique, Paris); Hansen, Jörgen (Concordia University) |
| Abstract: | We estimate a structural dynamic Roy model of education, labor supply and earnings on the 1979 and 1997 cohorts of males taken from the National Longitudinal Survey of Youth (NLSY) and evaluate to what extent changes in education and labor supply decisions across cohorts have been explained by changes in i) the college premium, ii) the utility of attending higher education, iii) grade progression standards, and iv) the value of non-market time. We quantify the evolution of the relative and absolute qualities of both college graduates and college attendants (associates). We find that it is impossible to rationalize changes in observed schooling decisions without appealing to a large increase in intrinsic taste for education, despite a doubling of the cost of college and its impact on debt-load. The population distribution of the college premium has shifted to the right, going from 50% to 58%, while the premium of actual college graduates has shifted to the left, going from 72% to 54%, thereby pointing toward a reduction of the relative quality of college graduates. The absolute quality (human capital) of college graduates has however remained stable. For college attendants (associates), both relative and absolute quality dropped. One implication of the relative flattening of age earnings profiles is the removal of the negative effect of late college graduation on early life-cycle wages. Our estimates indicate it moved from a 4% penalty per year of delay to an insignificant quantity by the early 2000's. |
| Keywords: | wage inequality, educational selectivity, wage distribution, college premium, dynamic discrete choice |
| JEL: | I2 J1 J3 |
| Date: | 2020–06 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp13356&r=all |
| By: | Freund, L. B; Rendahl, P. |
| Abstract: | This paper studies the role of uncertainty in a search-and-matching framework with risk-averse households. A mean-preserving spread to future productivity contracts current economic activity even in the absence of nominal rigidities, although the effect is reinforced by the presence of the latter. That is, uncertainty shocks carry both contractionary demand- and supply effects. The reason is that a more uncertain future increases the precautionary behavior of households, which reduces interest rates and contracts demand. At the same time, as future asset prices becomes more volatile and positively covary with aggregate consumption, households demand a larger risk premium, which puts negative pressure on current asset values and thereby contracts supply. Thus, in comparison to a pure negative demand shock, an uncertainty shock puts less deflationary pressure on the economy and, as a result, renders a flatter Phillips curve. |
| Keywords: | COVID-19, Uncertainty, unemployment, inflation, search frictions |
| JEL: | J64 E21 E32 |
| Date: | 2020–05–04 |
| URL: | http://d.repec.org/n?u=RePEc:cam:camdae:2035&r=all |
| By: | Aprajit Mahajan; Christian Michel; Alessandro Tarozzi |
| Abstract: | Time-inconsistency may play a central role in explaining inter-temporal behavior, particularly among poor households. However, little is known about the distribution of time-inconsistent agents, and time-preference parameters are typically not identified in standard dynamic choice models. We formulate a dynamic discrete choice model in an unobservedly heterogeneous population of possibly time-inconsistent agents. We provide conditions under which all population type probabilities and preferences for both time-consistent and sophisticated agents are point-identified and sharp set-identification results for naïve and partially sophisticated agents. Estimating the model using data from a health intervention providing insecticide treated nets (ITNs) in rural Orissa, India, we find that time-inconsistent agents account for almost 80 percent of our sample and that sophisticated and naïve agents are considerably present-biased. Counterfactuals show that the under-investment in ITNs attributable to present-bias leads to substantial costs that are about six times the price of an ITN. |
| JEL: | D9 I1 I3 |
| Date: | 2020–05 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:27198&r=all |
| By: | Nguyen, Van Phuong |
| Abstract: | According to the Basel Accord II, one of the key factors in the Internal-Ratings Based (IRB) framework is the Risk Weight Function (RWF). Indeed, it uses four risk components including PD, LGD, EAD, and M as input to yield the capital requirement and thereby Risk-Weighted Asset (RWA). Given the extremely important role of the Risk Weight Function, in this project, we aim to derive it mathematically. |
| Keywords: | Basel Accord II, Homogenous Loan Portfolio, Loss Distribution, Expected Loss, Unexpected Loss, Capital Requirement, Risk-Weight Functions. |
| JEL: | G00 G10 G11 G21 |
| Date: | 2019–12–01 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:100631&r=all |
| By: | Jorge Lorca; Emerson Melo |
| Abstract: | This paper studies the problem of optimal path selection in a directed network by decision makers that have an intrinsic distaste for evaluating too many options. We propose a recursive logit model that incorporates choice aversion along the lines introduced by Fudenberg and Strzalecki (2015). We derive optimal flow allocations both sequentially and from a path-choice perspective, which is robust to the presence of overlapping routes. We obtain a tight characterization of welfare in terms of both the network topology and the degree of choice aversion, where we derive comparative statics consistent with previous research. |
| Date: | 2020–05 |
| URL: | http://d.repec.org/n?u=RePEc:chb:bcchwp:879&r=all |
| By: | Xiao Xu |
| Abstract: | This paper is devoted to invest an optimal investment strategy for a defined-contribution (DC) pension plan under the Ornstein-Uhlenbeck (O-U) process and the loan. By considering risk-free asset, a risky asset driven by O-U process and a loan in the financial market, we firstly set up the dynamic equation and the asset market model which are instrumental in achieving the expected utility of ultimate wealth at retirement. Secondly, the corresponding Hamilton-Jacobi-Bellman(HJB) equation is derived by means of dynamic programming principle. The explicit expression for the optimal investment strategy is obtained by Legendre transform method. Finally, different parameters are selected to simulate the explicit solution and the financial interpretation of the optimal investment strategy is given. |
| Date: | 2020–05 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2005.10661&r=all |
| By: | Anton Kolotilin (School of Economics, UNSW Business School); Alexander Wolitzky (Department of Economics, MIT) |
| Abstract: | We consider a standard persuasion problem in which the receiver’s action and the state of the world are both one-dimensional. Fully characterizing optimal signals when utilities are non-linear is a daunting task. Instead, we develop a general approach to understanding a key qualitative property of optimal signals: their assortative structure, which describes the overall pattern of what states are pooled together. We derive simple conditions—driven by intuitive economic properties, such as supermodularity and submodularity of preferences—for the optimality of positive and negative assortative patterns of information disclosure. Our approach unifies a wide range of previous findings and generates new applications. |
| Keywords: | persuasion, information design, assortative matching |
| JEL: | C78 D82 D83 |
| Date: | 2020–06 |
| URL: | http://d.repec.org/n?u=RePEc:swe:wpaper:2020-08&r=all |
| By: | Howley, Peter; Ocean, Neel |
| Abstract: | Using an online survey with randomisation, we illustrate how identity-based utility can be harnessed to encourage pro-environmental behaviours. Results show that providing farmers with an opportunity to demonstrate their ‘green credentials’ increases their intention of maintaining environmental practices by an average of 19%, while the use of descriptive norms increases intent to participate in a biodiversity activity by an average of 8%. Interventions such as these represent a low-cost, yet powerful supplement to traditional policy tools. New approaches for engendering behavioural change are likely to be particularly important in a UK context as the UK transitions out of the EU. |
| Keywords: | Agricultural and Food Policy, Environmental Economics and Policy, Farm Management |
| Date: | 2020–04 |
| URL: | http://d.repec.org/n?u=RePEc:ags:aesc20:303705&r=all |