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on Utility Models and Prospect Theory |
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Issue of 2023‒12‒04
fifteen papers chosen by |
| By: | Takao Asano (Okayama University); Yusuke Osaki (Waseda University) |
| Abstract: | This paper considers a portfolio problem with one safe asset and one risky asset in the presence of background risk. We assume that the background risk is a non-financial variable and it is correlated to financial risk. The aim of this paper is to investigate the effect of correlation on portfolio choices. While we find that an increase in correlation lowers (raises) the expected utility for mixed correlation averse (seeking) individuals, contrary to intuition, it does not necessarily reduce (increase) the investment in the risky asset. We determine the conditions needed to reduce (increase) the investment and find that these conditions can be related to cross risk apportionment, which is the type of preferences for the combination of good and bad. We also introduce ambiguity into the correlation and investigate its effects on the portfolio choices. |
| Keywords: | Ambiguity, Bivariate Utility Function, Linear Payoff, Mixed Correlation Aversion (Seekingness), Background Uncertainty, Portfolio Choice |
| JEL: | D81 D91 G11 |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:kyo:wpaper:1098&r=upt |
| By: | Stark, Oded (University of Bonn) |
| Abstract: | I study attitudes towards risk taking in cases where a person relates to others positively, namely altruistically. This study is needed because it is unclear how altruism influences the inclination of an altruistic person to take risks. Will this person's risk-taking behavior differ if the utility of another person does not enter his utility function? Does being altruistic cause a person to become more reluctant to take risks because a risky undertaking turning sour will also damage his ability to make altruistic transfers? Or does altruism induce a person to resort to risky behavior because the reward for a successful outcome is amplified by the outcome facilitating a bigger transfer to the beneficiary of the altruistic act? Specifically, holding constant other variables, I ask: is an altruistic person more risk averse or less risk averse than a comparable person who is not altruistic? In response to this question, using a simple model in which preferences are represented by a logarithmic utility function, I show that an altruistic person who is an active donor (benefactor) is less risk averse than a comparable person who is not altruistic: altruism is a cause of greater willingness to take risks. The finding that the altruism trait causes greater willingness to take risks has not previously been noted in the existing literature. |
| Keywords: | altruism, altruistic transfers, relative risk aversion, intensity of altruism |
| JEL: | D01 D64 D81 G41 |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:iza:izadps:dp16573&r=upt |
| By: | Giuseppe Attanasi (Sapienza University of Rome, Italy; BETA, University of Strasbourg, France; Université Côte d'Azur, CNRS, GREDEG, France); Anna Maffioletti (Università degli Studi di Torino); Giulia Papini (Università degli Studi di Torino); Patrizia Sbriglia (Università degli Studi della Campania "Luigi Vanvitelli"); Maria Luigia Signore (Sapienza University of Rome, Italy) |
| Abstract: | The determination of a majority threshold in any voting system can be influenced by voters' attitudes towards uncertainty. Traditionally, a higher majority threshold is associated with a risk-averse attitude, serving as a means to protect against the tyranny of the majority. Moreover, the absence of ex-ante information regarding the likelihood of the voting outcome introduces a further layer of uncertainty, that of ambiguity, which motivates decision-makers to seek increased protection. In this study, we first provide a thorough formalization of this theoretical prediction, relying on a second-order expected utility model with both risk and ambiguity aversion of the voter toward the voting lottery. Second, we experimentally test its predictions by integrating the majority threshold implication into traditional experiments for risk and ambiguity elicitation. Through a series of classroom experiments run on 2020-2023 (about 1, 100 subjects in Italy & France), we analyze how individuals, placed under varying conditions of uncertainty, react to the determination of a barrier threshold. We find a strong correlation between the number of voters and the chosen quorum for a majority: as each subject is only aware of her own voting preference, expanding the electoral base results in a more ambiguous probability about the outcome. This favors more conservative behavior and results in an upward adjustment of the majority threshold. |
| Keywords: | voting lottery, majority threshold, risk and ambiguity attitude, theory-driven experiment |
| JEL: | D72 D81 C91 |
| Date: | 2023–06 |
| URL: | http://d.repec.org/n?u=RePEc:gre:wpaper:2023-12&r=upt |
| By: | Ian Dew-Becker; Stefano Giglio |
| Abstract: | The historical returns on equity index options are well known to be strikingly negative. That is typically explained either by investors having convex marginal utility over stock returns (e.g. crash/variance aversion) or by intermediaries demanding a premium for hedging risk. This paper examines the consistency of those explanations with returns on dynamically replicated, or synthetic, options. Theoretically, it derives conditions under which convex marginal utility leads synthetic options to also have negative excess returns. Empirically, synthetic options have CAPM alphas near zero over the period 1926--2022, in stark contrast to exchange-traded options. Over the last 15 years, returns on traded options have converged to those on synthetic options -- with the variance risk premium shrinking towards zero -- while various drivers of the cost and risk of hedging options exposures have declined, consistent with a model in which intermediaries drive option prices. |
| JEL: | G11 G12 G13 |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:nbr:nberwo:31833&r=upt |
| By: | Lida H. Aleksanyan; Armen E. Allahverdyan; Vardan G. Bardakhchyan |
| Abstract: | In the ultimatum game, the challenge is to explain why responders reject non-zero offers thereby defying classical rationality. Fairness and related notions have been the main explanations so far. We explain this rejection behavior via the following principle: if the responder regrets less about losing the offer than the proposer regrets not offering the best option, the offer is rejected. This principle qualifies as a rational punishing behavior and it replaces the experimentally falsified classical rationality (the subgame perfect Nash equilibrium) that leads to accepting any non-zero offer. The principle is implemented via the transitive regret theory for probabilistic lotteries. The expected utility implementation is a limiting case of this. We show that several experimental results normally prescribed to fairness and intent-recognition can be given an alternative explanation via rational punishment; e.g. the comparison between "fair" and "superfair", the behavior under raising the stakes etc. Hence we also propose experiments that can distinguish these two scenarios (fairness versus regret-based punishment). They assume different utilities for the proposer and responder. We focus on the mini-ultimatum version of the game and also show how it can emerge from a more general setup of the game. |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2311.03814&r=upt |
| By: | Claudia Cerrone; Anujit Chakraborty; Hyok Jung Kim; Leonhard Lades (Department of Economics, University of California Davis) |
| Abstract: | We use a real-effort experiment to jointly estimate present bias (β) and sophistication (̂ β) parameters, separately over money (βm, ̂ βm) and effort (βe, ̂ βe). Our novel incentive structure aligns the choice scenario with the canonical assumption of choices being the interior optima of a concave utility-maximization exercise. Participants choose to (and predict to) complete 14% (and 10%) fewer tasks on the same day than on a future day, leading to an estimated βe between 0.70 and .79 (and ̂ βe between 0.80 and .88). We find no evidence of present bias or sophistication over money |
| Keywords: | present bias, sophistication, beliefs, experiment, real effort task, experiment |
| Date: | 2023–11–06 |
| URL: | http://d.repec.org/n?u=RePEc:cda:wpaper:359&r=upt |
| By: | Pengguang Lu |
| Abstract: | This paper offers new insights into the role of trader bias on herding and contrarian behaviour in financial markets. We modify the behaviour of informed traders in a sequential trading microstructure model using prospect theory. Loss-averse informed traders with smaller probability bias than value bias never engage in herding, but contrarian behaviour and no trade are still feasible. These results align with current unexplained experimental observations. Our model offers flexibility for country-specific or stock-specific predictions, contingent on prospect theory parameters. We establish theoretical bias upper bound on loss attitude that triggers herding and contrarianism. Additionally, we found that contrarianism can have a more pronounced impact on prices and information efficiency than herding depending on the degree of trader bias. Our results are robust under various model specifications. |
| Keywords: | herding and contrarian; social learning; sequential trading; prospect theory |
| JEL: | D82 D83 D84 G14 G41 |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:man:sespap:2307&r=upt |
| By: | Marc Fleurbaey (PSE - Paris School of Economics - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris sciences et lettres - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement, CNRS - Centre National de la Recherche Scientifique, ENS-PSL - École normale supérieure - Paris - PSL - Université Paris sciences et lettres); Stéphane Zuber (CES - Centre d'économie de la Sorbonne - UP1 - Université Paris 1 Panthéon-Sorbonne - CNRS - Centre National de la Recherche Scientifique, CNRS - Centre National de la Recherche Scientifique, PSE - Paris School of Economics - UP1 - Université Paris 1 Panthéon-Sorbonne - ENS-PSL - École normale supérieure - Paris - PSL - Université Paris sciences et lettres - EHESS - École des hautes études en sciences sociales - ENPC - École des Ponts ParisTech - CNRS - Centre National de la Recherche Scientifique - INRAE - Institut National de Recherche pour l’Agriculture, l’Alimentation et l’Environnement) |
| Abstract: | Suppose that, for whatever reason, it is decided that inequalities within countries are more offensive than inequalities between countries, and that inequalities between populations living together are more offensive than inequalities between generations living in different times. Can a social welfare function express that preference? We show that it is actually difficult to incorporate such a localist preference into a social welfare function, except in a limited way (i.e., from a situation of specific similarity between countries). We also show that in order to obtain such preferences, the relative size of inequality aversion within and between countries may be counter-intuitive in some relevant cases, in the sense that a greater inequality aversion may happen to be required across countries than within countries. This research highlights new social welfare functions that aggregate the outcomes of evaluations over pairs of agents. |
| Keywords: | inequality aversion, transfer principle, within-country preference |
| Date: | 2023–10 |
| URL: | http://d.repec.org/n?u=RePEc:hal:cesptp:halshs-04270021&r=upt |
| By: | Martin Schnauss; Patrick Spieler |
| Abstract: | Holistic real estate strategies have to fulfill different interests and demands. Not only do qualitative and quantitative goals have to be reconciled, but also conflicting goals have to be resolved. This paper investigates how to create a real estate rating that captures the dynamic developments of real estate over its life cycle. A proprietary model is presented that is based on a dynamically evolving utility analysis and takes into account both changes in condition and the changing requirements of user groups. This dynamic model for a real estate rating therefore not only offers the possibility of depicting future developments of a property, but also has the potential to derive correspondingly comprehensible and needs-based real estate strategies. A dynamized utility analysis, especially in combination with a system dynamic modeling, offers the potential to develop needs-based real estate strategies over the entire life cycle of real estate. The developed model is applied to a simulation and evaluated by experts from the real estate industry. As a result, a needs-based real estate strategy is derived. |
| Keywords: | Dynamic; Rating; real estate; Simulation |
| JEL: | R3 |
| Date: | 2023–01–01 |
| URL: | http://d.repec.org/n?u=RePEc:arz:wpaper:eres2023_92&r=upt |
| By: | Anton Kolotilin; Roberto Corrao; Alexander Wolitzky |
| Abstract: | We consider general Bayesian persuasion problems where the receiver's utility is single-peaked in a one-dimensional action. We show that a signal that pools at most two states in each realization is always optimal, and that such pairwise signals are the only solutions under a non-singularity condition (the twist condition). Our core results provide conditions under which riskier prospects induce higher or lower actions, so that the induced action is single-dipped or single-peaked on each set of nested prospects. We also provide conditions for the optimality of either full disclosure or negative assortative disclosure, where all prospects are nested. Methodologically, our results rely on novel duality and complementary slackness theorems. Our analysis extends to a general problem of assigning one-dimensional inputs to productive units, which we call optimal productive transport. This problem covers additional applications including club economies (assigning workers to firms, or students to schools), robust option pricing (assigning future asset prices to price distributions), and partisan gerrymandering (assigning voters to districts). |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2311.02889&r=upt |
| By: | Dirk Engelmann (HU Berlin); Jana Friedrichsen (Christian-Albrechts-Universität Kiel); Roel van Veldhuizen (Lund University); Pauline Vorjohann (University of Exeter); Joachim Winter (LMU Munich) |
| Abstract: | Trust is an important condition for economic growth and other economic outcomes. Previous studies suggest that the decision to trust is driven by a combination of risk attitudes, distributional preferences, betrayal aversion, and beliefs about the probability of being reciprocated. We compare the results of a binary trust game to the results of a series of control treatments that by design remove the effect of one or more of these components of trust. This allows us to decompose variation in trust behavior into its underlying factors. Our results imply that beliefs are a key driver of trust, and that the additional components only play a role when beliefs about reciprocity are sufficiently optimistic. Our decomposition approach can be applied to other settings where multiple factors that are not mutually independent affect behavior. We discuss its advantages over the more traditional approach of controlling for measures of relevant factors derived from separate tasks in regressions, in particular with respect to measurement error and omitted variable bias. |
| Keywords: | trust; omitted-variable bias; measurement error; |
| JEL: | C90 D90 |
| Date: | 2023–11–16 |
| URL: | http://d.repec.org/n?u=RePEc:rco:dpaper:454&r=upt |
| By: | Keisuke Kizaki (Mizuho-DL Financial Technology); Taiga Saito (School of Commerce, Senshu University); Akihiko Takahashi (Graduate School of Economics, The University of Tokyo) |
| Abstract: | This paper considers a multi-agent optimal investment problem with conservative sentiments in an incomplete market by a BSDE approach. Particularly, we formulate the conservative sentiments of the agents by a sup-inf/inf-sup problem where we take infimum on a choice of a probability measure and supremum on trading strategies. To the best of our knowledge, this is the first attempt to investigate a multi-agent equilibrium model in an incomplete setting with heterogeneous views on Brownian motions. Moreover, we show a square-root case and a general case where the trading strategies and the excess return process of the risky asset in equilibrium are explicitly solved. Finally, we present numerical examples of the trading strategies and the expected return process in equilibrium under conservative sentiments, which explain how the sentiments affect the trading strategies of the agents and the expected return process of the risky asset. |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:cfi:fseres:cf575&r=upt |
| By: | Didier Nibbering |
| Abstract: | The number of parameters in a standard multinomial logit model increases linearly with the number of choice alternatives and number of explanatory variables. Since many modern applications involve large choice sets with categorical explanatory variables, which enter the model as large sets of binary dummies, the number of parameters in a multinomial logit model is often large. This paper proposes a new method for data-driven two-way parameter clustering over outcome categories and explanatory dummy categories in a multinomial logit model. A Bayesian Dirichlet process mixture model encourages parameters to cluster over the categories, which reduces the number of unique model parameters and provides interpretable clusters of categories. In an empirical application, we estimate the holiday preferences of 11 household types over 49 holiday destinations, and identify a small number of household segments with different preferences across clusters of holiday destinations. |
| Keywords: | large choice sets, Dirichlet process prior, multinomial logit model, highdimensional models |
| JEL: | C11 C14 C25 C35 C51 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:msh:ebswps:2023-19&r=upt |
| By: | Donato Masciandaro |
| Abstract: | Politicians can be more or less active in pursuing financial education policies in order to strength the financial literacy of the citizens, and consequently their trust. This paper explores the role of financial education policy in modifying the financial-trust endowment of a given population taking the political cost-benefit analysis into account. As, in any period, each incumbent government can design and implement its own financial education policy and as financial-literacy deficits are more likely in a period of financial innovation, we assume that constituencies more or l ess in favour of such policies are present in a given country. If this is the case, we can show that, in a democracy with political competition, the level of activism in implementing financial education policies is positively associated with financial-instability risks, literacy benefits, and illiteracy costs. Moreover, preferences and constraints motivate the politician in charge. More specifically, a more longer time horizons, lower psychological attitudes towards the status quo, and a higher probability of re-election can increase financial-literacy efforts. |
| Keywords: | financial literacy, financial education, financial trust, fintech, financial crisis, loss aversion, political competition |
| JEL: | D72 G28 G53 H10 K00 |
| Date: | 2023 |
| URL: | http://d.repec.org/n?u=RePEc:baf:cbafwp:cbafwp23208&r=upt |
| By: | Alireza Fallah; Michael I. Jordan |
| Abstract: | We study the role of regulatory inspections in a contract design problem in which a principal interacts separately with multiple agents. Each agent's hidden action includes a dimension that determines whether they undertake an extra costly step to adhere to safety protocols. The principal's objective is to use payments combined with a limited budget for random inspections to incentivize agents towards safety-compliant actions that maximize the principal's utility. We first focus on the single-agent setting with linear contracts and present an efficient algorithm that characterizes the optimal linear contract, which includes both payment and random inspection. We further investigate how the optimal contract changes as the inspection cost or the cost of adhering to safety protocols vary. Notably, we demonstrate that the agent's compensation increases if either of these costs escalates. However, while the probability of inspection decreases with rising inspection costs, it demonstrates nonmonotonic behavior as a function of the safety action costs. Lastly, we explore the multi-agent setting, where the principal's challenge is to determine the best distribution of inspection budgets among all agents. We propose an efficient approach based on dynamic programming to find an approximately optimal allocation of inspection budget across contracts. We also design a random sequential scheme to determine the inspector's assignments, ensuring each agent is inspected at most once and at the desired probability. Finally, we present a case study illustrating that a mere difference in the cost of inspection across various agents can drive the principal's decision to forego inspecting a significant fraction of them, concentrating its entire budget on those that are less costly to inspect. |
| Date: | 2023–11 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2311.02537&r=upt |