asset pricing with loss aversion using standard preferences for asset pricing has not been very successful to match asset price characteristics such as the risk free interest rate equity premium and the sharpe ratio to time series data behavioral nance has recently proposed more realistic preferences such as preferences with loss aversion to model asset pricing research has now started to explore the implications of behaviorally founded preferences for asset price characteristics encouraged by some studies of benartzki and thaler 1995 and barberis et al 2001 we study asset pricing with loss aversion in a production economy we here employ a stochastic growth model and use a stochastic version of a dynamic programming method with adaptive grid scheme to compute the above mentioned asset price characteristics of a model with loss aversion in preferences as our results show a model with loss aversion performs considerably better than pure consumption based asset pricing models

comparing behavioral models using data from experimental centipede games the centipede game posits one of the most well known paradoxes of backward induction in the literature of experimental game theory given that deviations from the unique subgame perfect nash equilibrium generates a pareto improvement several theoretical models have been employed in order to rationalize this kind of behavior in this social dilemma the available explanations range from social preferences including fairness altruism or cooperation motives errors in playing inability to perform backward induction or different depths of reasoning in the present study we use the blavatskyy s theoretical contribution and relax the assumptions of expected utility maximization and risk neutral attitudes to test an alternative explanation we compare various probabilistic decision theory models in terms of their descriptive in sample and predictive out of sample fit performance using data from experimental centipede games we find that introducing non expected utility preferences to the quantal response equilibrium model along with a nonlinear utility function provides a better explanation compared to alternative specifications such as the level k or the quantal response equilibrium model with altruistic motives jel c72 c92 d81 d82

applications of behavioural economics to tax evasion the paper reviews recent models that have applied the techniques of behavioural economics to the analysis of the tax compliance choice of an individual taxpayer the construction of these models is motivated by the failure of the yitzhaki version of the allingham sandmo model to predict correctly the proportion of taxpayers who will evade and the effect of an increase in the tax rate upon the chosen level of evasion recent approaches have applied non expected utility theory to the compliance decision and have addressed social interaction the models we describe are able to match the observed extent of evasion and correctly predict the tax effect but do not have the parsimony or precision of the yitzhaki model

optimism pessimism and financial bubbles this paper shows that it is possible to extend the scope of the existence of rational bubbles when uncertainty is introduced associated with rank dependent expected utility this rdu assumption can be viewed as a transformation of probabilities depending on the pessimism optimism of the agent the results show that pessimism favors the existence of deterministic bubbles when optimism may promote the existence of stochastic bubbles moreover under pessimism the rdu assumption may generate multiple bubbly equilibria the rdu assumption also leads to new conditions ensuring the absence of pareto optimality of the competitive equilibrium without bubbles these conditions still govern the existence of bubbles

cautious risk takers investor preferences and demand for active management actively managed mutual funds have distinct return distributions from their passive benchmarks and our theoretical analysis using tail sensitive risk preferences suggests that active value and growth funds may serve to reduce downside risk and capture upside potential respectively furthermore tail sensitivity measures estimated from the empirical pricing kernel have significant explanatory power for active fund flows even after controlling for business cycles and market wide sentiment finally active funds unlike their passive counterparts have exposures to option strategies hedging downside risk or capturing upside potential

risk rationality and time diversification the validity of the concept of time diversification is the subject of long running debate supporters of the concept argue that risk decreases as investment horizon increases detractors suggest that the concept is false on the face of it we argue that time diversification is consistent both theoretically and empirically with current conceptions of risk and rationality and we also note the implications of changes in investment horizon for stock market behavior

are preferences monotonic testing some predictions of regret theory in this paper the authors demonstrate that the assumption of regret aversion which has been invoked in regret theory to explain several well documented violations of expected utility theory also implies the existence of strict preferences between some stochastically equivalent actions and implies certain systematic violations of monotonicity the authors report an experimental test of these predictions they find that while choices between stochastically equivalent actions are entirely consistent with expected utility theory there is clear evidence of the monotonicity violations predicted by regret theory copyright 1992 by the london school of economics and political science

incentive effects of the u s welfare system a review the author would like to acknowledge support for prior work on this topic from the u s department of health and human services and helpful comments from three anonymous referees rebecca blank howard chernick john fitzgerald irwin garfinkel peter gottschalk edward gramlich david greenberg judith gueron james heckman v joseph hotz robert hutchens michael keane frank levy larry mead michael murray robert plotnick anuradha rangarajan philip robins howard rolston jeffrey smith and daniel weinberg all opinions and errors are those of the author alone

equilibrium asset pricing with epstein zin and loss averse investors abstract we study multi period equilibrium asset pricing in an economy with epstein zin ez agents whose preferences for consumption are represented by recursive utility and with loss averse la agents who derive additional utility of gains and losses and are averse to losses we propose an equilibrium gain loss ratio for stocks and show that the la agents are more less risk averse than the ez agents if their degree of loss aversion is higher lower than this ratio when all the agents have unitary relative risk aversion degree and elasticity of intertemporal substitution we prove the existence and uniqueness of the equilibrium and the market dominance of the ez agents in the long run finally we extend our results to the case in which the la agents use probability weighting in their evaluation of gains and losses

asset allocation with distorted beliefs and transaction costs abstract in this paper we study the problem of the optimal portfolio selection with transaction costs for a decision maker who is faced with knightian uncertainty the decision maker s portfolio consists of one risky and one risk free asset and we assume that the transaction costs are proportional to the traded volume of the risky asset the attitude to uncertainty is modeled by the choquet expected utility we derive optimal strategies and bounds of the no transaction region for both optimistic and pessimistic decision makers the no transaction region of a pessimistic investor is narrower and its bounds lie closer to the origin than that of an optimistic trader moreover under the choquet expected utility the structure of the no transaction region is not necessarily a closed interval as it is under the standard expected utility model

perceiving prospects properly when an agent chooses between prospects noise in information processing generates an effect akin to the winner s curse statistically unbiased perception systematically overvalues the chosen action because it fails to account for the possibility that noise is responsible for making the preferred action appear to be optimal the optimal perception patterns share key features with prospect theory namely overweighting of small probability events and corresponding underweighting of high probability events status quo bias and reference dependent s shaped valuations these biases arise to correct for the winner s curse effect

buyers pricing behavior for risky alternatives encoding processes and preference reversals numerous studies have examined individuals minimum selling prices or certainty equivalents for lotteries as measures of preference but few have examined maximum buying prices because every transaction involves a buyer as well as a seller buyers pricing behavior is of interest in its own right two prospect theory based descriptive models of maximum buying prices the integration and segregation models are developed from different assumptions about cognitive encoding processes the models were tested experimentally using an incentive compatible cash payoff scheme in which maximum buying prices for bets and choices between bets were elicited from subjects surprisingly observed maximum buying prices were far below expected values even for bets with probabilities of winning near 1 0 this suggests buyers are strongly influenced by loss aversion and that the conventional assumption that the buying price for a risky alternative is a reduction in the alternative s payoffs fails to describe behavior instead it appears subjects predominately employed a segregation encoding process in which the buying price was encoded separately from the bet s payoffs and treated as a sure loss however an additional result was not explained adequately by either encoding model buying prices were less risk averse than choices for 3 expected value bets creating preference reversals of the standard kind lichtenstein and slovic 1971 but more risk averse for 100 expected value bets creating reverse preference reversals casey 1991 implications for the scale compatibility principle tversky et al 1988 are discussed two theoretical approaches are outlined which offer promise in the development of a unified model of price judgments and choice preferences under risk

generalized disappointment aversion and asset prices we characterize generalized disappointment aversion gda risk preferences that can overweight lower tail outcomes relative to expected utility we show in an endowment economy that recursive utility with gda risk preferences generates effective risk aversion that is countercyclical this feature comes from endogenous variation in the probability of disappointment in the representative agent s intertemporal consumption saving problem that underlies the asset pricing model the variation in effective risk aversion produces a large equity premium and a risk free rate that is procyclical and has low volatility in an economy with a simple autoregressive endowment growth process the observed facts of aggregate risks and asset prices in the post war u s economy have led researchers to explore models of intertemporal preferences that generalize the well developed time additive expected utility specification used in the asset pricing economy of lucas 1978 in particular models that allow for countercyclical risk aversion have been shown to perform much better than the standard model see e g campbell and cochrane 1999 gordon and st amour 2000 and barberis huang and santos 2001 1 this leads us to explore the preference foundations that may produce this behavior endogenously our preference specification is a one parameter extension of the gul 1991 disappointment aversion utility function these new preferences

almost stochastic dominance and stocks for the long run abstract the geometric mean argument and the recently developed almost stochastic dominance criterion have been employed to make the case for stocks for the long run we show that almost stochastic dominance and the geometric mean argument do not necessarily support long run investment in equities in fact for standard preferences bonds may be preferred to stocks for the long run while stocks are preferred for shorter horizons

prospect theory and market quality abstract we study equilibrium trading strategies and market quality in an economy in which speculators display preferences consistent with prospect theory kahneman and tversky 39 tversky and kahneman 63 i e loss aversion and mild risk seeking in losses loss aversion risk seeking in losses induces speculators to trade less more and less cautiously more aggressively with their private information but also makes them less more inclined to purchase private information when it is costly in order to mitigate enhance their perceived risk of a trading loss we demonstrate that these forces have novel nontrivial state dependent effects on equilibrium market liquidity price volatility trading volume market efficiency and information production

the social welfare implications decomposability and geometry of the sen family of poverty indices in this paper we propose a unified framework for the sen indices of poverty intensity that shows an explicit connection between the indices and the common underlying social evaluation function we also identify the common multiplicative decomposition of the indices that allows simple and similar geometric interpretations and easy numerical computation jel classification c000 h000 o150 implications en termes de bien etre collectif decomposabilite et geometrie de la famille d indices de pauvretea la sen dans ce memoire les auteurs proposent un cadre d analyse integre des indices d intensite de pauvretea la sen qui souligne la relation explicite entre ces indices et la fonction sociale d evaluation commune qui les soustend les auteurs identifient aussi la decomposition multiplicative commune de ces indices qui permet d en donner des interpretations geometriques simples et idoines et de faire des calculs numeriques faciles

keeping up with the joneses and optimal diversification abstract peer effects have been shown to affect behavior and can generally lead to investments choices that are mean variance inefficient this paper analyzes optimal diversification with peer effects we show that if individuals have keeping up with the joneses preferences and they take their peer group reference as the market portfolio markowitz s mean variance efficiency analysis and the capm equilibrium are intact this holds for any keeping up preferences as well as heterogeneous combinations of such preferences these results also extend to the merton levy segmented market model

bargaining and boldness abstract we study a multiperson bargaining problem with general risk preferences through the use of shaked s game of cycling offers with exogenous breakdown if preferences are smooth then as the risk of breakdown vanishes the limiting outcome is one in which bargainers are equally marginally bold where a bargainer s marginal boldness measures his willingness to risk disagreement in return for a marginal improvement in his position under smoothness any ordinal nash solution is an equally marginally bold outcome however unlike the concept of the ordinal nash solution a unique equally marginally bold outcome exists in natural cases in particular if all bargainers have risk averse preferences of the rank dependent expected utility type for these preferences the equally marginally bold outcome maximizes a bargaining power adjusted asymmetric nash product where the degree of asymmetry is determined by the disparity in the marginal valuation of certainty among bargainers journal of economic literature classification numbers c72 c78 d81

eliciting subjective probabilities with binary lotteries abstract we evaluate a binary lottery procedure for inducing risk neutral behavior in a subjective belief elicitation task prior research has shown this procedure to robustly induce risk neutrality when subjects are given a single risk task defined over objective probabilities drawing a sample from the same subject population we find evidence that the binary lottery procedure also induces linear utility in a subjective probability elicitation task using the quadratic scoring rule we also show that the binary lottery procedure can induce direct revelation of subjective probabilities in subjects with popular non expected utility preference representations that satisfy weak conditions

optimal portfolio choice under loss aversion this paper analyzes the optimal investment strategy for loss averse investors assuming a complete market and general ito processes for the asset prices the loss averse investor follows a partial portfolio insurance strategy when the investor s planning horizon is short less than 5 years he or she considerably reduces the initial portfolio weight of stocks compared to an investor with smooth power utility the empirical section of the paper estimates the level of loss aversion implied by historical u s stock market data using a representative agent model we find that loss aversion and risk aversion cannot be disentangled empirically

local risk aversion in the rank dependent expected utility model first order versus second order effects abstract we evaluate locally the risk premium of a lottery in the framework of the rdeu model as the sum of two terms the first is a measure of risk aversion while the second is a measure of spreading aversion

ambiguity and uncertainty in ellsberg and shackle this paper argues that the similarities between ellsberg s and shackle s frameworks for discussing the limits of the probabilistic approach to decision theory are more important than usually admitted the paper discusses the grounds on which the ambiguity surrounding the decision maker in ellsberg s urn experiments can be deemed analogous to the uncertainty faced by shackle s entrepreneur taking crucial decisions the two authors insights are assessed and special attention is paid to the criteria for decision under uncertainty they put forward the paper establishes a link between ellsberg s and shackle s perspectives and the non additive probability approach of gilboa and schmeidler an approach that offers an alternative to standard probability calculus which can be of use to analyse both ambiguity and uncertainty the comparison between ellsberg and shackle draws on an interpretation of keynes s treatise on probability emphasising keynes s rejection of both well defined probability functions and maximisation as a guide to human conduct it is shown that keynes s viewpoint implies a reconsideration of the boundaries of probability theory that is in the same vein of ellsberg s and shackle s concern in the years of the consolidation of savage s new probabilistic mainstream copyright the author 2009 published by oxford university press on behalf of the cambridge political economy society all rights reserved oxford university press

do investors like to diversify a study of markowitz preferences we study rankings of completely and partially diversified portfolios and also of specialized assets when investors follow so called markowitz preferences it turns out that diversification strategies for markowitz investors are more complex than in the case of risk averse and risk inclined investors whose investment strategies have been extensively investigated in the literature in particular we observe that for markowitz investors preferences toward risk vary depending on their sensitivities toward gains and losses for example it turns out that unlike in the case of risk averse and risk inclined investors markowitz investors might prefer investing their entire wealth in just one asset this finding helps us to better understand some financial anomalies and puzzles such as the well known diversification puzzle which notes that some investors tend to concentrate on investing in only a few assets instead of choosing the seemingly more attractive complete diversification

existence and uniqueness of ordinal nash outcomes abstract in this paper we present necessary and sufficient conditions for existence and uniqueness of ordinal nash outcomes these outcomes are derived from the ordinal nash solution a reinterpretation and an extension of the nash bargaining solution that allows bargainers to have preference relations that are more general than expected utility our task is undertaken by the construction of a new notion called induced utilities journal of economic literature classification number c78

convergence in household credit demand across euro area countries evidence from panel data this article contributes to the literature on the convergence of financial systems in the euro area by estimating household credit demand in individual countries using the ardl framework advocated notably by pesaran et al 1999 the article provides evidence on the convergence of long run credit demand determinants interest rates investment and house prices in the largest euro area countries while short run dynamics remain heterogenous across countries the article also demonstrates that the equation uncovers demand rather than supply behaviour

credit markets with imperfect information risk aversion versus pessimism abstract stiglitz and weiss 1981 credit rationing is embedded within rank dependent expected utility theory our results show that sufficient pessimism or sufficient risk aversion by borrowers may eliminate adverse selection moreover lender optimism may eliminate credit rationing even when adverse selection exists

the impact of ceta programs on earnings a review of the literature this paper reviews and assesses evaluations of the comprehensive employment and training act ceta programs most of the studies found that the programs raised earnings by 200 to 600 annually in current dollars the programs were found to be more effective for women than men and public service employment and on the job training were generally found to be more effective activities than classroom training and work experience in spite of the broad overall agreement the studies differed significantly in many of their specific impact findings the nonexperimental nature of the data required the studies to make specific assumptions about selection procedures used to determine which individuals received training and the results are sensitive to the specific measures adopted data limitation and the inability to adequately test the validity of selection processes assumed make it impossible to determine which studies modeled the process correctly

individual preferences monetary gambles and stock market participation a case for narrow framing we argue that narrow framing whereby an agent who is offered a new gamble evaluates that gamble in isolation may be a more important feature of decision making than previously realized our starting point is the evidence that people are often averse to a small independent gamble even when the gamble is actuarially favorable we find that a surprisingly wide range of utility functions including many nonexpected utility specifications have trouble explaining this evidence but that this difficulty can be overcome by allowing for narrow framing our analysis makes predictions as to what kinds of preferences can most easily address the stock market participation puzzle

the probability premium a graphical representation we illustrate that pratt s probability premium can be given a simple graphical representation allowing a direct comparison to the equivalent but more prevalent concept of risk premium under expected utility we also show that the probability premium s graphical representation under the dual theory mimics that of the risk premium under expected utility

many good choice axioms when can many good lotteries be treated as money lotteries abstract without the independence axiom a weaker substitution axiom adi is necessary for the preferences over money lotteries induced by the money metric utility function to be well behaved given adi the agent s preferences over many good lotteries can be reconstructed from knowledge of preferences over money lotteries and over sure multivariate outcomes moreover other substitution properties of underlying many good lottery preferences are inherited by the money lottery preferences we analyze the formal and intuitive nature of adi and conclude that analysis of choice under uncertainty without adi cannot be one dimensional

social interaction and stock market participation we propose that stock market participation is influenced by social interaction in our model any given social investor finds the market more attractive when more of his peers participate we test this theory using data from the health and retirement study and find that social households those who interact with their neighbors or attend church are substantially more likely to invest in the market than non social households controlling for wealth race education and risk tolerance moreover consistent with a peer effects story the impact of sociability is stronger in states where stock market participation rates are higher

cumulative prospect theory option returns and the variance premium the variance premium and the pricing of out of the money otm equity index options are major challenges to standard asset pricing models we develop a tractable equilibrium model with cumulative prospect theory cpt preferences that can overcome both challenges the key insight is that the variance premium can be written as the expected return on a portfolio of otm call and put options and the probability weighting feature of cpt can explain the puzzlingly low returns observed for these options using gmm on a sample of u s index option returns between 1996 and 2010 we show that the cpt model ts well observed option prices and therefore the variance premium in a dynamic setting probability weighting and time varying equity return volatility combine to match the observed time series pattern of the variance premium

first order risk aversion heterogeneity and asset market outcomes we examine a wide range of two date economies populated by heterogeneous agents with the most common forms of nonexpected utility preferences used in finance and macroeconomics we demonstrate that the risk premium and the risk free rate in these models are sensitive to ignoring heterogeneity this follows because of endogenous withdrawal by nonexpected utility agents from the market for the risky asset this finding is important precisely because these alternative preferences have frequently been proposed as possible resolutions to various asset pricing puzzles and they have all been examined exclusively in a representative agent framework the well documented shortcomings of asset pricing models based in part on the expected utility eu hypothesis has motivated a large and rapidly grow ing set of pricing models that incorporate nonexpected utility preferences the pricing implications of these models in the existing literature have been based exclusively on the assumption of a single representative agent ra who prices assets using the aggregate endowment as the consumption process while ag gregation is well understood in the standard eu setting see constantinides 1982 it can be more complicated when some or all agents do not have eu we provide a simple and intuitive examination of the asset pricing implications of heterogeneity for the most commonly used alternatives to eu our primary finding is that the risk premium and the risk free rate are sensitive to ignoring heterogeneity in all of the simple two date non eu models that we examine we compare the prices in a model with two agent types to the prices in a model with a single representative agent who has a wealth weighted average of the utility parameters in the two agent economy the economies are otherwise identical for example they have the same endowment process market structure etc it is common for the single agent model to overstate the equity premium often by as much as 100 or more of the value in the two agent model and to understate the level of the risk free rate often by as much as 20 of the value in the two agent model

a theory of subjective compound lotteries abstract we develop a savage type model of choice under uncertainty in which agents identify uncertain prospects with subjective compound lotteries our theory permits issue preference that is agents may not be indifferent among gambles that yield the same probability distribution if they depend on different issues hence we establish subjective foundations for the anscombe aumann framework and other models with two different types of probabilities we define second order risk as risk that resolves in the first stage of the compound lottery and show that uncertainty aversion implies aversion to second order risk which implies issue preference and behavior consistent with the ellsberg paradox

house prices borrowing constraints and monetary policy in the business cycle i develop a general equilibrium model with sticky prices credit constraints nominal loans and asset prices changes in asset prices modify agents borrowing capacity through collateral value changes in nominal prices affect real repayments through debt deflation monetary policy shocks move asset and nominal prices in the same direction and are amplified and propagated over time the financial accelerator is not constant across shocks nominal debt stabilises supply shocks making the economy less volatile when the central bank controls the interest rate i discuss the role of equity debt indexation and household and firm leverage in the propagation mechanism finally i find that monetary policy should not target asset prices as a means of reducing output and inflation volatility

expected utility violations implications for agricultural and natural resource economics nomic toolkit they compare the dogged defense of eu by economists to that of a monty python character playing the role of a petstore owner disputing the state of an obviously dead parrot the shop owner goes through incredible machinations to avoid replacing the bird let us consider another analogy the behavior of a caged parrot can likely tell us very little about the behavior of parrots in the wild a biologist may want to incorporate the behavior of caged parrots into the study of wild birds but would undoubtedly need to be extremely careful about understanding the underlying differences in the opportunities and constraints faced by caged versus wild birds before inferring much about wild parrot behavior to some extent experimental violations of eu present us with the same problem as the hypothetical parrot biologist subjects in these risk experiments are in a setting and are completing tasks very different from the setting and tasks they face in their everyday economic and social context what is missing relates to the power of the rationality assumption discussed in friedman that relies not only on the person s skill but also on the feedback they receive from the market friedman s expert billiards players are selected by a market because of their skill in billiards and th se are the players who fit friedman s as if description 1 risk researchers should not ignore experimental data however before we eliminate eu we should more fully understand the underlying reasons for the experimental behavior that violates eu agricultural and natural resource economists are well suited to assess

the benefits of differential variance based constraints in portfolio optimization abstract the main problem of portfolio optimization is parameter estimation error various methods have been suggested to mitigate this problem among which are shrinkage resampling bayesian updating naive diversification and imposing constraints on the portfolio weights this study suggests two substantial extensions of the constrained optimization approach the variance based constraints vbc and the global variance based constraints gvbc methods by the vbc method the constraint imposed on the weight of a given stock is inversely proportional to its standard deviation the higher a stock s sample standard deviation the higher the potential estimation error of its parameters and therefore the tighter the constraint imposed on its weight gvbc employs a similar idea but instead of imposing a sharp boundary constraint on each stock a quadratic cost is assigned to deviations from the naive 1 n weight and a single global constraint is imposed on the total cost of all deviations comparing ten optimization methods we find that the two new suggested methods typically yield the best performance as measured by the sharpe ratio gvbc ranks first these results are obtained for two different datasets and are also robust to the number of assets under consideration

the spirit of capitalism and expectation driven business cycles abstract while news shocks are believed to be instrumental in explaining business cycles many existing models fail to predict a boom in consumption investment employment output and asset prices in response to good news about future productivity a model with the intrinsic desire for wealth is shown to generate the aforementioned responses a news driven boom is explained predominantly by an expansion of labor supply and is characterized by the falling real wage the simulated model not only captures well conventional business cycle statistics but also reproduces countercyclical real returns and hump shaped responses of hours and output to an unexpected technology shock

discrete time behavioral portfolio selection under cumulative prospect theory we formulate and study three multi period behavioral portfolio selection models under cumulative prospect theory i s shaped utility maximization without probability weighting in a market with one risky asset ii s shaped utility maximization without probability weighting in a market with multiple risky assets which follow a joint elliptical distribution and iii s shaped utility maximization with inverse s shaped probability weighting in a market with one risky asset for the first two time consistent models we identify the well posedness conditions and derive the semi analytical optimal policies for the third time inconsistent model we assume that the investor is aware of the time inconsistency but is unable to commit to his initial plan of action then we reformulate the model into an intrapersonal game model and derive the semi analytical subgame perfect nash equilibrium time consistent policy under well posedness condition all the three policies take a piecewise linear feedback form our analysis of the three models not only partially explains the well documented phenomena of non participation puzzle and horizon effect but also extends the two fund separation theorem into multi period s shaped utility setting and pushes forward the study on time inconsistency issue incurred by probability weighting

stochastic dominance in regret theory the regret theory of choice under uncertainty is known to admit intransitivities in preference relations in this paper the stochastic dominance properties of the theory are examined it is shown that the usual definition of first stochastic dominance is not satisfied by regret theoretic preferences and that in general violations of first stochastic dominance are not merely permitted but required an exact characterization of the stochastic dominance rule corresponding to regret theoretic preferences is presented this concept is weaker than the usual definition but stronger than the notion of statewise dominance in which one prospect yields a preferred outcome with probability 1 theories of choice under uncertainty have proliferated in recent years after a long period in which the expected utility eu approach of von neumann and morgenstern 1944 was pre eminent the breakdown of the dominance in eu theory reflects the increasing body of evidence that the choices made by many people systematically violate the predictions of the theory the axiomatic foundations of the theory and in particular the independence axiom have also received severe questioning ever since the famous critique of allais 1953

optimal asset allocation risk and information uncertainty abstract in asset allocation problem the distribution of the assets is usually assumed to be known in order to identify the optimal portfolio in practice we need to estimate their distribution the estimations are not necessarily accurate and it is known as the uncertainty problem many researches show that most people are uncertainty aversion and this affects their investment strategy in this article we consider risk and information uncertainty under a common asset allocation framework the effects of risk premium and covariance uncertainty are demonstrated by the worst scenario in a set of measures generated by a relative entropy constraint the nature of the uncertainty and its impacts on the asset allocation are discussed

asset pricing in a lucas fruit tree economy with the best and worst in mind this paper studies a lucas 1978 fruit tree economy under the assumption that the agents are choquet expected utility ceu rather than standard expected utility decision makers more speci cally the agents non additive beliefs about the economy s dividend payment process are modelled as neo additive capacities so that the agents decision behavior emphasizes the best respectively worst possible economic scenarios in contrast to existing models of lucas type economies with ambiguity averse agents epstein and wang 1994 which ensure dynamic consistency through heavy restrictions on admissible ambiguity attitudes my ap

a theory of anticipated utility abstract a new theory of cardinal utility with an associated set of axioms is presented it is a generalization of the von neumann morgenstern expected utility theory which permits the analysis of phenomena associated with the distortion of subjective probability

heterogeneous agents and the implications of the markowitz model of utility for multi prize lottery tickets abstract the purpose in this letter is to demonstrate employing two parametric forms of the markowitz model of utility that heterogeneity of preferences of markowitz agents can contribute towards an explanation of why lotteries typically have multiple rather than single prizes

diversification versus optimality is there really a diversification puzzle abstractin this paper we provide a general valuation of the diversification attitude of investors first we empirically examine the diversification of mean variance optimal choices in the us stock market during the 11 year period 2003 2013 we then analyze the diversification problem from the perspective of risk averse investors and risk seeking investors second we prove that investors optimal choices will be similar if their utility functions are not too distant independent of their tolerance or aversion to risk finally we discuss investors attitude towards diversification when the choices available to investors depend on several parameters

modelling the demand for loans to the private sector in the euro area this article studies the determinants of loans to the private sector in the euro area using the johansen methodology the study identifies one cointegrating relationship linking real loans gdp and interest rates this relationship implies that in the long run real loans are positively related to real gdp and negatively to real short term and long term interest rates both the signs and the magnitude of the coefficients suggest that the cointegrating vector describes a long run demand equation the short run dynamics of the demand for euro area real loans is subsequently modelled by means of a vector error correction model vecm a number of specification tests performed on the vecm produce satisfactory results with tests of stability of the model parameters showing no signs of structural breaks during the sample period 1980 1 1999 2 all of this suggests that developments in real loans to the private sector in the euro area can be reasonably explained by the model

discounting behavior a reconsideration we re evaluate the theory experimental design and econometrics behind claims that individuals exhibit non constant discounting behavior theory points to the importance of controlling for the non linearity of the utility function of individuals since the discount rate is defined over time dated utility flows and not flows of money it also points to a menagerie of functional forms to characterize different types of non constant discounting behavior the implied experimental design calls for individuals to undertake several tasks to allow us to identify these models and to several treatments such as multiple horizons and the effect of allowing for a front end delay on earlier payments the implied econometrics calls for structural estimation of the theoretical models allowing for joint estimation of utility functions and discounting functions using data collected from a representative sample of 413 adult danes in 2009 we draw striking conclusions assuming an exponential discounting model we estimate discount rates to be 5 6 on average this is significantly lower than all previous estimates using controlled experiments we also find no evidence to support quasi hyperbolic discounting or fixed cost discounting and only modest evidence to support other specifications of non constant discounting furthermore the evidence for non constant discounting while statistically significant is not economically significant in terms of the size of the estimated discount rates we undertake extensive robustness checks on these findings including a detailed review of the previous comparable literature

prospect theory and mean variance analysis the experimental results of prospect theory pt reveal suggest that investors make decisions based on change of wealth rather than total wealth that preferences are s shaped with a risk seeking segment and that probabilities are subjectively distorted this article shows that while pt s findings are in sharp contradiction to the foundations of mean variance mv analysis counterintuitively when diversification between assets is allowed the mv and pt efficient sets almost coincide thus one can employ the mv optimization algorithm to construct ptefficient portfolios the markowitz 1952a tobin 1958 mean variance mv rule is probably the most popular investment decision rule under uncertainty in economics and in finance and it is widely employed by both academics and practitioners the strength of the mv analysis is that in the case of normal return distributions the choice of any expected utility maximizing risk averse individual will be according to the mv rule 1 the mv framework is the foundation of the sharpe 1964 lintner 1965 capital asset pricing model capm which is a cornerstone of modern finance moreover the mv framework provides a very important practical procedure for the construction of efficient portfolios while standard economic theory and in particular mv analysis assume expected utility maximization and risk aversion in a breakthrough article kahneman and tversky 1979 show that the actual behavior of individuals systematically and consistently violates these

the nash bargaining solution for decision weight utility functions abstract a simple derivation of the non expected utility nash outcome as defined in rubinstein et al 1992 rubinstein a safra z thomson w 1992 on the interpretation of the nash bargaining solution and its extension to non expected utility preferences econometrica 60 1171 1186 is given for the class of decision weight utility functions conditions for existence and uniqueness are provided

risk management strategies via minimax portfolio optimization recent extreme economic developments nearing a worst case scenario motivate further examination of minimax linear programming approaches for portfolio optimization risk measured as the worst case return is employed and a portfolio from maximizing returns subject to a risk threshold is constructed minimax model properties are developed and parametric analysis of the risk threshold connects this model to expected value along a continuum revealing an efficient frontier segmenting investors by risk preference divergence of minimax model results from expected value is quantified and a set of possible prior distributions expressing a degree of knightian uncertainty corresponding to risk preference determined the minimax model will maximize return with respect to one of these prior distributions providing valuable insight regarding an investor s risk attitude and decision behavior linear programming models for financial firms to assist individual investors to hedge against losses by buying insurance and a model for designing variable annuities are proposed

stochastic dominance tests abstract we develop stochastic dominance tests of a given prospect compared with multiple choice alternatives we account for all types of preferences the tests are formulated in terms of linear as well as mip models and developed based on bayesian analysis which relies on novel markov chain monte carlo procedures empirical results indicate that the market portfolio is prospect stochastic dominance optimal this implies that there are s shaped utility functions that rationalize the market portfolio

mean variance portfolio selection with at risk constraints and discrete distributions we examine the impact of adding either a var or a cvar constraint to the mean variance model when security returns are assumed to have a discrete distribution with finitely many jump points three main results are obtained first portfolios on the var constrained boundary exhibit k 2 fund separation where k is the number of states for which the portfolios suffer losses equal to the var bound second portfolios on the cvar constrained boundary exhibit k 3 fund separation where k is the number of states for which the portfolios suffer losses equal to their vars third an example illustrates that while the var of the cvar constrained optimal portfolio is close to that of the var constrained optimal portfolio the cvar of the former is notably smaller than that of the latter this result suggests that a cvar constraint is more effective than a var constraint to curtail large losses in the mean variance model 2007 elsevier b v all rights reserved

household portfolio diversification a case for rank dependent preferences the proliferation of novel preference theories in financial economics is hampered by a lack of non experimental evidence and by the theories additional complexity which has not been shown to be critical in applications in this article i present arguments in support of preferences with rank dependency using the survey of consumer finances data i document two widespread patterns inconsistent with expected utility i many households simultaneously invest in well deversified funds and in poorly diversified portfolios of stocks and ii some households with substantial savings do not invest anything in equities i show that portfolio choice models with rank dependent preferences plausibly parameterized and under fully rational assumptions are quantitatively consistent with the observed diversification these results call for further efforts to integrate the models of rank dependent preferences in portfolio theory and asset pricing the decision theoretic literature has long acknowledged the shortcomings of the expected utility theory of von neumann and morgenstern 1944 several generalizations of the theory are inspired by the experimental evidence and aimed at improving its descriptive accuracy however there are few applications of new models of preferences in finance and expected utility continues to dominate the field 1 two principal hurdles slow the proliferation of novel preferences in financial economics first the lack of empirical non experimental or field data confirming that the behavior motivating non expected utilities is widespread outside the laboratory settings second the additional and often significant complexity of the alternative preferences which has not been shown to be critical in applications where the models based on expected utility fall short of reasonable predictions this article presents empirical and theoretical this paper was previously circulated under the title household portfolio diversification the paper has benefited from the comments of shlomo benartzi luca benzoni markus brunnermeier john dickhaut maria perozek raj singh hersh shefrin and workshop participants at minnesota finance bag lunch 2003 wharton conference household financial decision making and portfolio choice and 2003 summer meetings of econometric society i would like to thank cam harvey the editor and an anonymous referee for many helpful comments and suggestions a special thanks to jack kareken for comments and editorial help on an earlier draft i am grateful to donna zerwitz for editorial assistance the views expressed herein are those of the author and not necessarily of the federal reserve bank of minneapolis or the federal reserve system all errors and omissions are the sole responsibility of the author address correspondence to valery polkovnichenko finance 3 122 csom 319 19 th

dynamic portfolio choice and asset pricing with narrow framing and probability weighting this paper shows that the framework proposed by barberis and huang 2009 to incorporate narrow framing and loss aversion into dynamic models of portfolio choice and asset pricing can be extended to also account for probability weighting and for a value function that is convex on losses and concave on gains we show that the addition of probability weighting and a convex concave value function reinforces previous applications of narrow framing and cumulative prospect theory to understanding the stock market non participation puzzle and the equity premium puzzle moreover we show that a convex concave value function generates new wealth effects that are consistent with empirical observations on stock market participation

prospect theory much ado about nothing prospect theory is a paradigm challenging the expected utility paradigm one of the fundamental components of prospect theory is the s shaped value function the value function is mainly justified by experimental investigation of the certainty equivalents of prospects confined either to the negative or to the positive domain but not of mixed prospects which characterize most actual investments we conduct an experimental study withmixed prospects using for the first time recently developed investment criteria called prospect stochastic dominance psd and markowitz stochastic dominance msd we reject the s shaped value function showing thatat least 62 76 of the subjects cannot be characterized by such preferences we find support for the markowitz utility function which is a reversed s shaped function exactly the opposite of the prospect theory value function it is possible that the previous results supporting the s shaped value function are distorted because the prospects had only positive or only negative outcomes presenting hypothetical situations which individuals do not usually face and which are certainly not common in financial markets

the invention of the independence condition for preferences this paper discusses the history and interrelations of three central ideas in preference theory the independence condition in decision under risk the sure thing principle in decision under uncertainty and conjoint independence for multiattribute decisions and consumer theory independence was recognized as an important component of decision under risk in the late 1940s by jacob marschak john nash herman rubin and norman dalkey and first appeared in publication in marschak marschak j 1950 rational behavior uncertain prospects and measurable utility econometrica18 111 141 and nash nash j f 1950 the bargaining problem econometrica18 155 162 the sure thing principle can be credited to savage savage l j 1953 une axiomatisation du comportement raisonnable face i l incertitude colloq internal centre national rech sci 40 econometrie 29 40 savage l j 1954 the foundations of statistics wiley new york 2nd edn dover new york 1972 conjoint independence for consumer theory was introduced by sono sono m 1943 the effect of price changes on the demand and supply of separable goods in japanese kokumin keisai zasshi74 1 51 and leontief leontief w w 1947a a note on the interrelation of subsets of independent variables of a continuous function with continuous first derivatives bull amer math soc 53 343 350 leontief w w 1947b introduction to a theory of the internal structure of functional relationships econometrica51 361 373 a form of it can also be recognized in samuelson samuelson p a 1947 foundations of economic analysis harvard university press cambridge ma presented earlier in samuelson samuelson p a 1940 foundations of analytical economics the observational significance of economic theory ph d dissertation harvard university boston ma independence and the sure thing principle are equivalent for decision under risk but in a less elementary way than has sometimes been thought the sure thing principle for decision under uncertainty and conjoint independence are identical in a mathematical sense the mathematics underlying our three preference conditions has an older history the independence condition for decision under risk can be recognized in the characterization of associative means and conjoint independence for multiattribute decisions in solutions to the generalized associativity functional equation

choice under uncertainty evidence from ethiopia india and uganda we review experimental evidence collected from risky choice experiments using poor subjects in ethiopia india and uganda using these data we estimate that just over 50 of our sample behaves in accordance with expected utility theory and that the rest subjectively weight probability according to prospect theory our results show that inferences about risk aversion are robust to whichever model we adopt when we estimate each model separately however when we allow both models to explain portions of the data simultaneously we infer risk aversion for subjects behaving according to expected utility theory and risk seeking behaviour for subjects behaving according to prospect theory

portfolio optimization under loss aversion abstract we present an integrated methodological approach for selecting portfolios the proposed methodology is focused on incorporation of investor s preferences in the mean risk framework we propose a risk measure calculated with the downside part of the portfolio return distribution which we argue captures better the practical behavior of the loss averse investor we establish its properties study the link with stochastic dominance criteria point out the relations with conditional value at risk and lower partial moment of first order and give the explicit formula for the case of scenario based portfolio optimization the proposed methodology involves two stages firstly the investment opportunity set efficient frontier is determined and secondly one single preferred efficient portfolio is selected namely the one having the highest expected utility value three classes of utility functions with loss aversion corresponding to three types of investors are considered the empirical study is targeted on assessing the differences between the efficient frontier of the proposed model and the classical mean variance mean cvar and mean lpm1 frontiers we firstly analyze the loss of welfare incurred by using another model instead of the proposed one and measure the corresponding gain loss of utility secondly we assess how much the portfolios really differ in terms of their compositions using a dissimilarity index based on the 1 norm we describe and interpret the optimal solutions obtained and emphasize the role and influence of loss aversion parameters values and of constraints three types of constraints are studied no short selling allowed a certain degree of diversification imposed and short selling allowed

fuzzy logic and preference uncertainty in non market valuation in seeking to value environmental amenities and public goods individuals often have trouble trading off the vague good or amenity against a monetary measure valuation in these circumstances can best be described as fuzzy in terms of the amenity being valued perceptions of property rights and the numbers chosen to reflect values in this paper we apply fuzzy logic to contingent valuation employing a fuzzy clustering approach for incorporating preference uncertainty obtained from a follow up certainty confidence question we develop a fuzzy random utility maximization frum framework where the perceived utility of each individual is fuzzy in the sense that an individual s utility belongs to each cluster to some degree the model is then applied to a swedish survey that elicited residents willingness to pay for enhanced forest conservation and to a canadian survey of agricultural landowners that elicited their willingness to accept compensation for a tree planting program both the wtp and wta measures we obtain using the fuzzy approach are well below those obtained using standard probability methods based on goodness of fit measures and monte carlo experimentation a case can be made for using a fuzzy preference approach for modeling preference uncertainty as opposed to incorporating respondent uncertainty within the random utility maximization framework

optimism and pessimism in games this paper considers the impact of ambiguity in strategic situations it extends the earlier literature by allowing for optimistic responses to ambiguity ambiguity is modelled by ceu preferences we propose a new solution concept for players who may express ambiguitypreference then we study comparative statics of changes in ambiguity attitude in games with strategic complements this gives a precise statement of the impact of ambiguity on economic behaviour

child support welfare dependency and poverty female headed families have among the highest poverty rates of any major demographic group in the united states the purpose of this paperis to investigate empirically the effectiveness of current child support enforcement policies and to determine their role in reducing poverty and welfare dependency a special supplement to the april 1982 current population survey provides the data for the analysis the results indicate that child support enforce ment may represent an effective means for re ducing welfare program costs but isunlikely to have a dramatic effect on either welfare de pendency or poverty copyright 1986 by american economic association

portfolio optimization with disutility based risk measure abstract in this paper we propose a quantile based risk measure which is defined using the modified loss distribution according to the decision maker s risk and loss aversion the properties related to different classes of disutility functions are established a portfolio selection model in the mean risk framework is proposed and equivalent formulations of the model generating the same efficient frontier are given the advantages of this approach are investigated using real world data from nyse the differences between the efficient frontier of the proposed model and the classical mean variance and mean cvar are quantified and interpreted extensive experiments show that the efficient portfolios obtained by using the proposed model exhibit lower risk levels and an increased satisfaction compared to the other two mean risk models

electricity generation cost in isolated system the complementarities of natural gas and renewables in the canary islands abstract the canary islands offer an example of an isolated electric grid of relative important size within the eu due to its peculiarities the role of renewable energies and their complementarity with fossil fuels offers a solid path to achieving the main energy policy goals of the islands the purpose of this paper is to assess the current situation and the energy objectives proposed in the energy plan of the canaries pecan 2006 for the electricity industry taking into account the average cost and the risk associated with the different alternatives for generating electricity by means of the mean variance portfolio theory our analysis highlights the inefficiency of the current electricity generating mix in terms of cost risk and lack of diversification shifting toward an efficient system would involve optimizing the use of endogenous energy sources and introducing natural gas to generate electricity this scenario would mean reducing both cost and risk by almost 30 each as well as atmospheric co 2 emissions our results agree with the pecan philosophy

a model of casino gambling we show that prospect theory offers a rich theory of casino gambling one that captures several features of actual gambling behavior first we demonstrate that for a wide range of preference parameter values a prospect theory agent would be willing to gamble in a casino even if the casino offers only bets with no skewness and with zero or negative expected value second we show that the probability weighting embedded in prospect theory leads to a plausible time inconsistency at the moment he enters a casino the agent plans to follow one particular gambling strategy but after he starts playing he wants to switch to a different strategy the model therefore predicts heterogeneity in gambling behavior how a gambler behaves depends on whether he is aware of the time inconsistency and if he is aware of it on whether he can commit in advance to his initial plan of action this paper was accepted by brad barber teck ho and terrance odean special issue editors

the demand for commercial bank loans and the lending rate abstract this paper presents a two equation structural model of short term loans and the lending rate estimated with quarterly data for the netherlands the emphasis is on the fact that the lending rate is observed as a zone rather than as a unique and directly measurable market price an important empirical result is that the interest rate elasticity of loan demand is significant this conclusive finding confirms the intuitive feeling with regard to the importance of the rate of interest for credit prevailing in the banking community but is seldom found in empirical econometrics

market efficiency of oil spot and futures a mean variance and stochastic dominance approach this paper examines the market efficiency of oil spot and futures prices by using both mean variance mv and stochastic dominance sd approaches based on the west texas intermediate crude oil data for the sample period 1989 2008 we find no evidence of any mv and sd relationships between oil spot and futures indices this infers that there is no arbitrage opportunity between these two markets spot and futures do not dominate one another investors are indifferent to investing spot or futures and the spot and futures oil markets are efficient and rational the empirical findings are robust to each sub period before and after the crises for different crises and also to portfolio diversification

stochastic dominance analysis without the independence axiom we characterize the consistency of a large class of nonexpected utility preferences including mean variance preferences and prospect theory preferences with stochastic orders for example stochastic dominances of different degrees our characterization rests on a novel decision theoretic result that provides a behavioral interpretation of the set of all derivatives of the functional representing the decision maker s preferences as an illustration we consider in some detail prospect theory and choice acclimating preferences two popular models of reference dependence under risk and we show the incompatibility of loss aversion with prudence this paper was accepted by james smith decision analysis

portfolio choice in personal equilibrium abstract this paper finds that in portfolio choice where reference point arises endogenously in personal equilibria investors behave as if they had a concave probability weighting function this finding establishes a link between the reference dependent utility and the rank dependent utility theories

welfare improving ambiguity in insurance markets with asymmetric information we consider a model of competitive insurance markets involving both asymmetric information and ambiguity about the accident probability we show that there can exist a full insurance pooling equilibrium we also present an example where an increase in ambiguity leads to a strict pareto improvement higher ambiguity relaxes high risks incentive compatibility constraint and allows low risks to buy more insurance higher ambiguity also deteriorates low risks expected utility from holding an uncertain prospect if the former effect dominates the expected utility of low risks increases and given that high risks utility remains unaffected the increase in ambiguity implies a strict pareto improvement

policy watch proposals for time limited welfare this paper summarizes the clinton administration s welfare reform proposal and views the available evidence on the effects of time limiting cash assistance and requiring work among long term aid to families with dependent children users the reforms are designed to increase employment among aid to families with dependent children recipients given changes in the labor market for less skilled workers it is not clear that this will increase income among these families the reform proposals would shift antipoverty spending toward work subsidies child support collection efforts and subsidized jobs that support mandated employment it is unclear that this will produce either a cheaper or more effective antipoverty system than the current one

first order risk aversion and the equity premium puzzle abstract this paper integrates yaari s dual theory of choice under uncertainty into a multiperiod context and examines its implications for the equity premium puzzle an important property of these preferences is that of first order risk aversion which implies in our model that the risk premium for a small gamble is proportional to the standard deviation rather than the variance since the standard deviation of the growth rate in aggregate consumption is considerably larger than its variance the model can generate both a small risk free rate and a moderate equity premium