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on Utility Models and Prospect Theory |
| By: | Larry Epstein; Shaolin Ji |
| Abstract: | We formulate a model of utility for a continuous time framework that captures the decision-maker's concern with ambiguity or model uncertainty. The main novelty is in the range of model uncertainty that is accommodated. The probability measures entertained by the decision-maker are not assumed to be equivalent to a fixed reference measure and thus the model permits ambiguity about which scenarios are possible. Modeling ambiguity about volatility is a prime motivation and a major focus. Implications for asset returns are derived in representative agent frameworks, in both Arrow-Debreu style economies and in sequential Radner-style economies. |
| Date: | 2011–03 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:1103.1652&r=upt |
| By: | Douch, Mohamed; Bouaddi, Mohammed |
| Abstract: | Standard consumption-based asset pricing models focus on the consumption risk, seen as the only source of fluctuations and information about risk for the informed investor. These models, however, can account for high expected excess stock return only when assuming implausible relative risk aversion. This paper adds additional risk factors to the standard C-CAPM model to resolve both the equity premium and the risk-free rate puzzles as well as the risk-free rate volatility puzzle. By adding other relevant risk factors, the resulting pricing model is able to explain these puzzles relying on admissible range of local relative risk aversion. The model generates, also, a time-varying relative risk aversion and intertemporal elasticity of substitution. |
| Keywords: | Common factors; factor analysis; principal components; asset pricing; equity premium puzzle; risk free rate puzzle. |
| JEL: | G12 G10 |
| Date: | 2010–12 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:29440&r=upt |
| By: | Bateman, Hazel; Ebling, Christine; Geweke, John; Jordan, Louviere; Stephen, Satchell; Susan, Thorp |
| Abstract: | This research studies the propensity of individuals to violate implications of expected utility maximization in allocating retirement savings within a compulsory de- ned contribution retirement plan. The paper develops the implications and describes the construction and administration of a discrete choice experiment to almost 1200 members of Australias mandatory retirement savings scheme. The experiment nds overall rates of violation of roughly 25%, and substantial variation in rates, depend- ing on the presentation of investment risk and the characteristics of the participants. Presentations based on frequency of returns below or above a threshold generate more violations than do presentations based on the probability of returns below or above thresholds. Individuals with low numeracy skills, assessed as part of the ex-periment, are several times more likely to violate implications of the conventional expected utility model than those with high numeracy skills. Older individuals are substantially less likely to violate these restrictions, when risk is presented in terms of event frequency, than are younger individuals. The results pose significant questions for public policy, in particular compulsory de ned contribution retirement schemes, where the future welfare of participants in these schemes depends on quantitative decision-making skills that a signi cant number of them do not possess. |
| Keywords: | discrete choice; retirement savings; investment risk; household finance; financial literacy |
| JEL: | G23 G28 D14 |
| Date: | 2011–12 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:29371&r=upt |
| By: | Schilirò, Daniele |
| Abstract: | The essay analyzes the decision process in economics and its relationship with the concept of rationality starting from the theory of rational choice, that is, a systemic approach based on the formal axiomatic method applied mainly in the microeconomic field, which has become the heart of neoclassical economics. The work also focuses on the important contribution of the cognitive economics to the concept of rationality and, consequently, of criticism that this theoretical approach moves to the standard economic theory in the definition of choices, indicating a systematic discrepancy between theory and empirical evidence. Moreover, the analysis puts forward the topic of rational expectations, as the rationality of expectations concerns the preferences, and also because the hypothesis of rational expectations has characterized the development of modern macroeconomics and influenced the issue of the efficient use of information by the economic agents. This work wants to highlight, using a very little formal language, the complexity of the choice process and the unsolved relationship between economic and psychological dimensions of such a process, but at the same time it wants to argue that the economic theory as a whole is far away today from an abstract conception perfectly rational and fully informed individuals which choose without making mistakes. |
| Keywords: | decisione; razionalità; incertezza; aspettative |
| JEL: | D84 D01 |
| Date: | 2011–03–08 |
| URL: | http://d.repec.org/n?u=RePEc:pra:mprapa:29477&r=upt |
| By: | Lesourd, Jean-Baptiste; Schilizzi, Steven |
| Abstract: | We examine under what conditions setting up a captive insurance company with reinsurance is an optimal solution for risk-averse firms when the insured firm, the insurer and the reinsurer do not know the probability distribution of some risks, and have conflicting estimates of this distribution. |
| Keywords: | corporate insurance, reinsurance, uncertainty, ambiguity, non-conventional risks, captive insurance companies, Risk and Uncertainty, D81, G22, Q2, |
| Date: | 2011–02–22 |
| URL: | http://d.repec.org/n?u=RePEc:ags:uwauwp:100886&r=upt |
| By: | Julien Jacob |
| Abstract: | We consider a firm, from a high-risk industry, facing two available technologies. One of the two technologies is ambiguous in the sense that its probability of accident lies in a interval of objective probabilities. The firm has the possibility to invest in seeking information in order to reduce the uncertainty inherent to the ambiguous technology. We apply a model inspired by Jaffray (1989) on imprecise probabilities to study the firm’s behavior in such a context. Considering a strict liability rule, we compare the impact of two liability regimes, unlimited liability and limited liability, on the firm’s technical choice. Whatever the firm’s information seeking policy, which type of liability regime promotes which technology depends on the relative value of the marginal operating costs of the two technologies. |
| Keywords: | Technical choice, technological risk, unlimited liability, limited liability, ambiguity. |
| JEL: | D21 D81 K32 |
| Date: | 2011 |
| URL: | http://d.repec.org/n?u=RePEc:ulp:sbbeta:2011-06&r=upt |
| By: | Giovanni Cespa (Cass Business School, CSEF, and CEPR); Xavier Vives (IESE Business School) |
| Abstract: | We propose a theory that jointly accounts for an asset illiquidity and for the asset price potential over-reliance on public information. We argue that, when trading frequencies differ across traders, asset prices reect investors' Higher Order Expectations (HOEs) about the two factors that inuence the aggregate demand: fundamentals information and liquidity trades. We show that it is precisely when asset prices are driven by investors' HOEs about fundamentals that they over-rely on public information, the market displays high illiquidity, and low volume of informational trading; conversely, when HOEs about fundamentals are subdued, prices under-rely on public information, the market hovers in a high liquidity state, and the volume of informational trading is high. Over-reliance on public information results from investors' under-reaction to their private signals which, in turn, dampens uncertainty reduction over liquidation prices, favoring an increase in price risk and illiquidity. Therefore, a highly illiquid market implies higher expected returns from contrarian strategies. Equivalently, illiquidity arises as a byproduct of the lack of participation of informed investors in their capacity of liquidity suppliers, a feature that appears to capture some aspects of the recent crisis. |
| Keywords: | Expected returns, multiple equilibria, average expectations, over-reliance on public information, Beauty Contest. |
| JEL: | G10 G12 G14 |
| Date: | 2011–03–09 |
| URL: | http://d.repec.org/n?u=RePEc:sef:csefwp:276&r=upt |