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on Utility Models and Prospect Theory |
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Issue of 2021‒04‒19
eighteen papers chosen by |
| By: | Daniel J. Benjamin (University of California Los Angeles & NBER); Mark Alan Fontana (Hospital for Special Surgery & Weill Cornell Medical College); Miles Kimball (University of Colorado Boulder & NBER) |
| Abstract: | Risk aversion is typically inferred from real or hypothetical choices over risky lotteries, but such “untutored” choices may reflect mistakes rather than preferences. We develop a procedure to disentangle preferences from mistakes : after eliciting untutored choices, we confront participants with their choices that are inconsistent with expected-utility axioms (broken down enough to be self-evident) and allow them to reconsider their choices. We demonstrate this procedure via a survey about hypothetical retirement investment choices administered to 596 Cornell students. We find that, on average, reconsidered choices are more consistent with almost all expected-utility axioms, with one exception related to regret. |
| Keywords: | risk aversion, mistakes, retirement investing, framing effects, expected utility |
| JEL: | D63 D81 G11 H8 |
| Date: | 2020–10–21 |
| URL: | http://d.repec.org/n?u=RePEc:cth:wpaper:gru_2020_026&r=all |
| By: | Hanna, Vanessa (Université catholique de Louvain, LIDAM/ISBA, Belgium); Hieber, Peter; Devolder, Pierre (Université catholique de Louvain, LIDAM/ISBA, Belgium) |
| Abstract: | In many countries, the decline in interest rates has reduced the interest in traditional participating life insurance contracts with investment guarantees and has led to a shift to unit-linked policies without guarantees. We design a novel mixed insurance contract splitting premium payments between a participating and a unit-linked fund. An additional guarantee fee is applied on the unit-linked return in order to increase the investment guarantee of the participating fund. In a utility-based framework, using power utility and prospect theory as preference functions, we show that the mixed product is usually perceived more attractive than a full investment in either the unit-linked or the participating contract. The guarantee fee is beneficial for conservative investors interested in a stronger protection against losses. This is also interesting from a marketing perspective: By the increase of the guarantee in the participating product, zero or negative guaranteed rates can be avoided. |
| Keywords: | Life and pension insurance ; Participating contract ; Unit-linked contract ; Investment guarantee ; Mixed insurance contracts ; Expected utility ; Cumulative prospect theory |
| Date: | 2021–02–23 |
| URL: | http://d.repec.org/n?u=RePEc:aiz:louvad:2021010&r=all |
| By: | Hans-Martin von Gaudecker; Axel Wogrolly; Christian Zimpelmann |
| Abstract: | This paper analyses the stability and distribution of ambiguity attitudes using a broad population sample. We employ four waves of data from a survey instrument with high-powered incentives. Structural estimation of random utility models yields three individual-level parameters: Ambiguity aversion, likelihood insensitivity or perceived level of ambiguity, and the variance of decision errors. We demonstrate that these parameters are very heterogeneous but fairly stable over time and across domains. These contexts span financial markets—our main application—and climate change. The ambiguity parameters are interdependent in their interpretation and the precision of their estimates depends on decision errors. To describe heterogeneity in these three dimensions, we adopt a discrete classification approach. A third of our sample comes rather close to the behaviour of expected utility maximisers. Half of the sample is characterized by a high likelihood insensitivity, with thirty per cent ambiguity-averse and twenty per cent making ambiguity-seeking choices for most events. For the remaining eighteen per cent, we estimate sizeable error parameters, which implies that no robust conclusions about their ambiguity attitudes are possible. Predicting group membership with a large number of observed characteristics shows reasonable patterns. |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:bon:boncrc:crctr224_2021_272&r=all |
| By: | Charles-Cadogan, G. (University of Leicester) |
| Abstract: | Under Bruno De Finetti’s coherence theory of additive probability, the expected value of a sequence of mutually exclusive bets should not expose the bettor to certain loss for any of the bets in the sequence (i.e. no formation of Dutch books). However, decision makers (DMs) are known to have non-additive probability preferences represented in the frequency domain. This conundrum of choice implies that DMs are incoherent. If so, then preference reversal (PR) is more likely to occur. That is, DMs response to choice and valuation procedures (with similar expected value) are more likely to be dissimilar or their preferences may appear to be intransitive. We prove that even when the true states of choice experiments are procedure invariance and transitive preferences, PR will still be observed because of : (1) phase incoherence between paired gambles with the same expected value–when probability cycles are incomplete, and (2) experimenter interference in probability measurement. We introduce a utility coherence ratio for paired gambles, and estimates from simulated phase transition from incoherent states to coherent states in binary choice to illustrate the theory. We find that coherence measures are very sensitive to measurement error, coherent states have higher frequency phase transition, and incoherent states represent momentary lapse in judgment that eventually disappear. So, Dutch books and PR are prevented. |
| Keywords: | preference reversal ; transitivity axiom ; probability phase incoherence ; wavelets ; probability weighting JEL codes: C00 ; C02 ; C44 ; D03 ; D81 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:wrk:wcreta:69&r=all |
| By: | Christopher Turansick |
| Abstract: | The random utility model is known to be unidentified. However, there are times when a data set is uniquely rationalizable by the random utility model. We ask the question for which data sets does the random utility model have a unique representation. Our first result characterizes which data sets admit a unique representation. Our second result provides a finite test which determines if a distribution of preferences is observationally equivalent to some other distribution of preferences. We then explore the implications of our results in the context of other random utility models. |
| Date: | 2021–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2102.05570&r=all |
| By: | Matias Selser; Javier Kreiner; Manuel Maurette |
| Abstract: | We apply Reinforcement Learning algorithms to solve the classic quantitative finance Market Making problem, in which an agent provides liquidity to the market by placing buy and sell orders while maximizing a utility function. The optimal agent has to find a delicate balance between the price risk of her inventory and the profits obtained by capturing the bid-ask spread. We design an environment with a reward function that determines an order relation between policies equivalent to the original utility function. When comparing our agents with the optimal solution and a benchmark symmetric agent, we find that the Deep Q-Learning algorithm manages to recover the optimal agent. |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2104.04036&r=all |
| By: | Minglian Lin; Indranil SenGupta |
| Abstract: | In this paper, we consider the portfolio optimization problem in a financial market under a general utility function. Empirical results suggest that if a significant market fluctuation occurs, invested wealth tends to have a notable change from its current value. We consider an incomplete stochastic volatility market model, that is driven by both a Brownian motion and a jump process. At first, we obtain a closed-form formula for an approximation to the optimal portfolio in a small-time horizon. This is obtained by finding the associated Hamilton-Jacobi-Bellman integro-differential equation and then approximating the value function by constructing appropriate super-solution and sub-solution. It is shown that the true value function can be obtained by sandwiching the constructed super-solution and sub-solution. We also prove the accuracy of the approximation formulas. Finally, we provide a procedure for generating a close-to-optimal portfolio for a finite time horizon. |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2104.06293&r=all |
| By: | Ricky Li |
| Abstract: | I provide an axiomatization of stochastic utility over two periods, stating testable necessary and sufficient conditions under which an agent's choice behavior under exogenous menu selection can be modeled by a pair of random utility functions. Although static random utility is characterized by a single axiom, Block-Marschak nonnegativity, I demonstrate that an additional notion of marginal consistency is needed for the two-period axiomatization. In particular, when each period's choice set has size three, I restate the characterization using the simpler axiom of stochastic regularity. I conclude by stating several corollaries, including an axiomatization of stochastic utility with full support and an axiomatization of n-period stochastic utility. |
| Date: | 2021–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2102.00143&r=all |
| By: | Matthew Kovach |
| Abstract: | This paper provides a behavioral analysis of conservatism in beliefs. I introduce a new axiom, Dynamic Conservatism, that relaxes Dynamic Consistency when information and prior beliefs "conflict." When the agent is a subjective expected utility maximizer, Dynamic Conservatism implies that conditional beliefs are a convex combination of the prior and the Bayesian posterior. Conservatism may result in belief dynamics consistent with confirmation bias, representativeness, and the good news-bad news effect, suggesting a deeper behavioral connection between these biases. An index of conservatism and a notion of comparative conservatism are characterized. Finally, I extend conservatism to the case of an agent with incomplete preferences that admit a multiple priors representation. |
| Date: | 2021–01 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2102.00152&r=all |
| By: | Marco F. Boretto; Fausto Cavalli; Ahmad Naimzada |
| Abstract: | We study the effects on the Nash equilibrium of the presence of a structure of social interdependent preferences in a Cournot oligopoly, described in terms of a game in which the network of interactions reflects on the utility functions of firms through a combination of weighted profits of their competitors as in [7]. Taking into account the channels of social and market interactions, we detail the consequence of preference interdependence on the best response of a firm, focusing on both direct and high degree of interdependence effects between two given firms. We characterize the Nash equilibrium in terms of social and market interactions among firms, through a Bonacich-like centrality measure and a scalar index describing the degree of competitiveness that characterizes an oligopoly with interdependent preferences. Finally, we study the equilibrium of some scenarios described by regular structures of interaction. |
| Keywords: | Cournot Game, Preference interdependence, Nash Equilibrium |
| JEL: | D43 C62 C70 |
| Date: | 2021–03 |
| URL: | http://d.repec.org/n?u=RePEc:mib:wpaper:463&r=all |
| By: | Daniel Sevcovic; Cyril Izuchukwu Udeani |
| Abstract: | In this paper, we investigate a fully nonlinear evolutionary Hamilton-Jacobi-Bellman (HJB) parabolic equation utilizing the monotone operator technique. We consider the HJB equation arising from portfolio optimization selection, where the goal is to maximize the conditional expected value of the terminal utility of the portfolio. The fully nonlinear HJB equation is transformed into a quasilinear parabolic equation using the so-called Riccati transformation method. The transformed parabolic equation can be viewed as the porous media type of equation with source term. Under some assumptions, we obtain that the diffusion function to the quasilinear parabolic equation is globally Lipschitz continuous, which is a crucial requirement for solving the Cauchy problem. We employ Banach's fixed point theorem to obtain the existence and uniqueness of a solution to the general form of the transformed parabolic equation in a suitable Sobolev space in an abstract setting. Some financial applications of the proposed result are presented in one-dimensional space. |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2104.06115&r=all |
| By: | Federico Echenique; Alfred Galichon |
| Abstract: | We characterize solutions for two-sided matching, both in the transferable and in the nontransferable-utility frameworks, using a cardinal formulation. Our approach makes the comparison of the matching models with and without transfers particularly transparent. We introduce the concept of a no-trade matching to study the role of transfers in matching. A no-trade matching is one in which the availability of transfers do not affect the outcome. |
| Date: | 2021–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2102.04337&r=all |
| By: | Alfred Galichon; Bernard Salani\'e |
| Abstract: | We present a class of one-to-one matching models with perfectly transferable utility. We discuss identification and inference in these separable models, and we show how their comparative statics are readily analyzed. |
| Date: | 2021–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2102.02564&r=all |
| By: | Pierre-André Chiappori (Columbia University); Bernard Salanié (Columbia University) |
| Abstract: | The economic analysis of the "market for marriage" has a long tradition. Two more recent developments have made it the focus of renewed interest: new models of household behavior, and a class of tractable specifications for econometric work. These two threads have converged to generate richer predictions and empirical applications. The aim of the current survey is to provide an overview of recent advances in the theory of matching markets. |
| Keywords: | household behavior, utility transfer, bipartite matching |
| JEL: | J12 D13 |
| Date: | 2021–04 |
| URL: | http://d.repec.org/n?u=RePEc:hka:wpaper:2021-016&r=all |
| By: | Frondel, Manuel; Osberghaus, Daniel; Sommer, Stephan |
| Abstract: | Based on panel data on around 5,500 German household heads originating from four years, this paper analyzes whether the experience of financial losses due to the Corona pandemic has affected three kinds of personal traits and preferences: the willingness to take risks, patience, and the locus of control. Our empirical results indicate that patience and the locus of control remain unchanged by the experience of pandemic-related financial losses, whereas we find a significantly negative effect of severe financial losses on risk taking, contrasting with the traditional assumption that such preferences are constant. In this respect, our heterogeneity analysis indicates that financial losses due to Corona particularly affect the most vulnerable households, notably low-income households and those with little income diversification. |
| Keywords: | Patience,risk aversion,locus of control |
| JEL: | D91 C23 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:zbw:zewdip:21029&r=all |
| By: | Francesca de Petrillo (IAST - Institute for Advanced Study in Toulouse); Alexandra Rosati (University of Michigan [Ann Arbor] - University of Michigan System) |
| Abstract: | Uncertainty is a ubiquitous component of human economic behaviour, yet people can vary in their preferences for risk across populations, individuals and different points in time. As uncertainty also characterizes many aspects of animal decision-making, comparative research can help evaluate different potential mechanisms that generate this variation, including the role of biological differences or maturational change versus cultural learning, as well as identify human-unique components of economic decision-making. Here, we examine decision-making under risk across non-human primates, our closest relatives. We first review theoretical approaches and current methods for understanding decision-making in animals. We then assess the current evidence for variation in animal preferences between species and populations, between individuals based on personality, sex and age, and finally, between different contexts and individual states. We then use these primate data to evaluate the processes that can shape human decision-making strategies and identify the primate foundations of human economic behaviour. |
| Keywords: | non-human primates,risk,economic behaviour,individual variation,cooperation |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:hal:journl:hal-03151858&r=all |
| By: | Tommaso M. Valletti; André Veiga |
| Abstract: | We conduct an experiment where subjects read online news articles and are shown ads for brands next to those articles. Using eye-tracking technology, we measure the attention that each individual devotes to each article and ad. Then, respondents choose between cash or vouchers for the brands advertised. Attention to ads is a predictor both of willingness-to-pay for brands, and brand recall. The main predictors of attention include the type of news and the match between individual political preferences and the media outlet. |
| Keywords: | online-advertising, experiments, attention, e-commerce, targeting |
| JEL: | M37 C91 L86 |
| Date: | 2021 |
| URL: | http://d.repec.org/n?u=RePEc:ces:ceswps:_8991&r=all |
| By: | Ivar Ekeland; Alfred Galichon |
| Abstract: | This paper exhibits a duality between the theory of Revealed Preference of Afriat and the housing allocation problem of Shapley and Scarf. In particular, it is shown that Afriat's theorem can be interpreted as a second welfare theorem in the housing problem. Using this duality, the revealed preference problem is connected to an optimal assignment problem, and a geometrical characterization of the rationalizability of experiment data is given. This allows in turn to give new indices of rationalizability of the data, and to define weaker notions of rationalizability, in the spirit of Afriat's efficiency index. |
| Date: | 2021–02 |
| URL: | http://d.repec.org/n?u=RePEc:arx:papers:2102.02593&r=all |