Lecture 3: Prospect Theory, Framing, and Mental Accounting. Expected Utility Theory. The key features are as follows:
|
|
- August Farmer
- 5 years ago
- Views:
Transcription
1 Topics Lecture 3: Prospect Theory, Framing, and Mental Accounting Expected Utility Theory Violations of EUT Prospect Theory Framing Mental Accounting Application of Prospect Theory, Framing, and Mental Accounting: Equity Premium Puzzle Master of Arts program in Applied Finance Nattawut Jenwittayaroje, Ph.D, CFA NIDA Business School 1 2 Expected Utility Theory The key features are as follows: The value is measured by utility. Utility depends on the state of wealth. A rational individual s utility function is assumed to be a positive function of wealth. The expected utility of a prospect is probability-weighted utility (i.e., the sum of the products of utilities times their probabilities). The weight put on any outcome probability is simply equal to its probability. A rational, risk-averse individual s utility function is assumed to be a concave function of wealth. Utility x-y x x+y Wealth 3 4
2 Allais Paradox The Allais paradox is a choice problem designed by Maurice Allais to show an inconsistency of actual observed choices with the predictions of expected utility theory. Allais question 2: Which do you prefer? Allais Paradox (con t) Allais question 1: Which do you prefer? A. a 100% chance of getting $1,000,000, or A* a gamble where the outcomes are as follows:» a 1% chance of getting nothing» a 89% chance of getting $1,000,000» a 10% chance of getting $5,000, or 6 B. a gamble where the outcomes are as follows:» a 89% chance of getting nothing» A 11% chance of getting $1,000,000 B* a gamble where the outcomes are as follows:» a 90% chance of getting nothing» a 10% chance of getting $5,000,000. Allais Paradox (con t) From Question 1: U(1,000,000) > 0.89U(1,000,000) +.10U(5,000,000) Rearranging we get: 0.11U(1,000,000) > 0.10U(5,000,000) From Question 2: 0.10U(5,000,000) > 0.11U(1,000,000) Such choices are clearly contradictory!! Reconsidering Allais Paradox Modified Question 1: Which do you prefer? A. a gamble where the outcomes are as follows:» a 89% chance of getting $1,000,000» a 11% chance of getting $1,000,000, or A* a gamble where the outcomes are as follows:» a 89% chance of getting $1,000,000» a 1% chance of getting nothing» a 10% chance of getting $5,000,
3 Reconsidering Allais Paradox (con t) Modified question 2: Which do you prefer? or B. a gamble where the outcomes are as follows:» a 89% chance of getting nothing» A 11% chance of getting $1,000,000 B* a gamble where the outcomes are as follows:» a 89% chance of getting nothing» a 1% chance of getting nothing» a 10% chance of getting $5,000,000. Reconsidering Allais Paradox (con t) Notice that after removing commonalities, now the choices between prospect A and A* or B and B* are exactly the same! Thus people should choose (A and B) or (A* and B*). Without such aids, many people do not seem to understand the structure of the decision and choose A and B* Problems with expected utility theory A number of violations of expected utility have been discovered. Expected utility theory assumes that people should have consistent choices, regardless of presentation (i.e., frame). A decision frame is defined to be a decision-maker s view of the problem and possible outcomes. A frame is affected by the presentation mode and the individual s perception of the question, and personal characteristics. People have different perspectives and come up with different decisions depending on how a problem is framed. Sometimes frames are opaque, and thus trickier to see through. For this reason, a change in frame can lead to a change in decision, as in Allais questions. 11 Problems with expected utility theory A number of violations of expected utility have been discovered. Alternative theories have been developed which seek to account for these violations. Best-known is prospect theory of Daniel Kahneman and Amos Tversky. 12
4 Prospect theory Prospect theory was developed by Kahneman and Tversky base on observing actual behavior. Experimental evidence says that people often behave contrary to expected utility theory. Expected utility theory is normative. What people should do While prospect theory is positive. What people actually do Risk aversion vs. risk seeking Prospect pair 1 -- choose between: A: (.5, 6,000, 0.5, 0) B: (3,000) In other words, the choice is between a sure gain of $3,000 and a 50% chance to gain 6,000. Prospect pair 2 choose between: C: (.5, -6,000, 0.5, 0) D: (-3,000) In other words, the choice is between a sure loss of $3,000 and a 50% chance to lose 6, Key Aspect 1 Reference Point For Prospect pair 1, 84% of the respondents chose B, consistent with risk aversion. For Prospect pair 2, 84% of the respondents chose C, consistent with risk seeking. Expected Utility theory cannot incorporate changes in risk attitude like this. People sometimes exhibit risk aversion and sometimes exhibit risk seeking, depending on the nature of the prospect. If you are richer by $5,000 and you have to choose between A) a 50% chance to win $6,000 and a 50% chance to win nothing B) receive $3,000. If you are richer by $11,000 and you have to choose between C) a 50% chance to lose $6,000 and a 50% chance to lose nothing D) lose $3,
5 Key Aspect 2 Notice that the two decisions are effectively the same. But 72% chose B) and 64% chose C) The problem shows that risk attitude is not the same across gains and losses. seem gains or losses is what people care about, rather than the level of wealth. People evaluate an outcome based on the gain or loss from a reference point (usually taken to be current wealth or status quo). Expected Utility theory people value outcomes based on the final wealth position, regardless of the person s initial wealth. Peoples valuations of prospects depend on gains and losses relative to a reference point. This reference point is usually the status quo. Loss aversion Prospect pair 3 -- choose between: A: no prospect B: (0.5, $100, -$100) A is the status quo. Most choose A. Losses loom larger than gains. In other words, the loss of $100 is more painful than a gain of $100 is pleasurable. This is called loss aversion Key Aspect 3 Prospect pair 4 -- choose between: A: no prospect B: (0.5, $X, -$25) What value of X would make you indifferent between A and B? The average person requires a gain of $61 to be indifferent between accepting or rejecting the gamble. People are averse to losses because losses loom larger than gains. 19 Development of prospect theory These and other results led to prospect theory as an alternative to expected utility theory. Key precepts: Value function in prospect theory replaces the utility function in expected utility theory. Value is in terms of gains or losses, relative to a reference point (usually the status quo). Risk aversion (i.e., concave) in positive domain Risk seeking (i.e., convex) in negative domain Loss aversion people dislike losses, so the value function is steeper for losses than for gains. 20
6 (Utility) Value $100 Losses($) $100 Gains ($) The Prospect Theory (Utility) Value Function Expected Utility (EU) vs Prospect Theory Barberis and Thaler (2003) Should financial economists be interested in alternatives to expected utility? It may be that EU theory is a good approximation to how people evaluate a risky gamble like the stock market, even if it does not explain attitudes to the kinds of gambles studied in experimental settings. However, they go on to say: On the other hand, the difficulty the EU approach has encountered in trying to explain basic facts about the stock market suggests that it may be worth taking a closer look at the experimental evidence. Indeed, recent work in behavioral finance has argued that some of the lessons we learn from violations of EU are central to understanding a number of financial phenomena Some more prospects Prospect pair 5 you are given $1000 then choose between: A: (.5, another $1000) B: ($500) Prospect pair 6 you are given $2000 then choose between: A: (.5, -$1000) B: (-$500) Results for 5: most prefer B. Results for 6: most prefer A. Problems are identical! People have chosen differently because of different frames. An odder example You must make two lottery choices. One draw will be in morning; other in afternoon. Prospect pair 7: A: ($2400) B: (.25, $10,000) Most people (84%) choose 7A. Prospect pair 8: A: (-$7500) B: (.75, -$10,000) Most people (87%) prefer 8B
7 An odder example (con t.) Suppose now you have another prospect to decide. Prospect pair 9: A: (0.25, $2,400, -$7,600) B: (0.25, $2,500, -$7,500) (All) People choose 9B. An odder example (con t.) But combining 7A and 8B leads to: (0.25, $2400, -$7,600) 9A And combining 7B and 8A leads to: (0.25, $2500, -$7,500) 9B While 7B and 8A can be seen to be better than 7A and 8B when framed as 9B and 9A, most people do not see through the opaque framing in the original two decisions. Why? They have difficulty getting past frame Another example: Framing with nonmonetary outcomes Imagine that Thailand is preparing for the outbreak of an unusual disease, which is expected to kill 1,000 people. Two alternative programmes, A and B, have been proposed to combat the disease. (Survival Frame): If A is adopted, 250 people will be saved. If B is adopted, there is 25% that 1,000 will be saved, and 75% that no people will be saved. Which of the two programs do you choose? 27 Another example: Framing with nonmonetary outcomes Consider another situation Imagine that Thailand is preparing for the outbreak of an unusual disease, which is expected to kill 1,000 people. Two alternative programmes, C and D, have been proposed to combat the disease. (Mortality Frame): If C is adopted, 750 people will die. If D is adopted, there is 25% that nobody will die, and 75% that 1,000 people will die. Which of the two programs do you choose? 28
8 Another example: Framing with nonmonetary outcomes (Note that A = C, and B = D). Of the respondents to the first problem (Survival Frame), about 72% chose program A. People are risk averse for gains lives saved are seen as gains. The reference point here starts from full mortality. The second problem (Mortality Frame), 78% chose program D. By contrast, they are risk seeking for losses the current reference point is that nobody has yet died (or full survival), so any deaths are seen as losses. Another example: Framing with nonmonetary outcomes The results are consistent with prospect theory. In other words, we again have loss aversion and framing dependence. Therefore, in order to understand and model asset prices or trading behaviour of investors, we need to make some assumptions about investor preferences and how investors make decisions under risky situations Mental accounting Related to prospect theory and frames. Mental accounting is the set of cognitive operations used by individuals and households to organize, evaluate, and keep track of financial activities. Expenditure accounts (foods, housing, entertainment), Wealth account (checking account, retirement savings) Note that these accounts are mental constructs rather than actual accounts. Mental accounting is beneficial. For example, it helps people exert self-control, encouraging the use of rules such as don t dip into retirement savings, pay for luxuries out of savings. 31 Mental accounting However, often tendency to use mental accounting leads to odd and suboptimal decisions. Traditionally, economists assume that funds are fungible (substitutable). But, because of mental accounting, this may not be so. Actual decisions people make indicate that money is not always substitutable. A few highlights of mental accounting follow 32
9 Theater ticket problems 1. Imagine you have decided to see a play where admission is $10. As you enter theater you discover that you have lost a $10 bill. Would you still pay $10 for a ticket to the play? 2. Imagine that you have decided to see a play and paid the admission price of $10 per ticket. As you enter the theater you discover that you have lost the ticket. The seat was not marked and the ticket cannot be recovered. Would you pay $10 for another ticket? 33 Theater ticket problems cont. Nothing is really different about the problems. However, Of respondents given first question, 88% said they would buy a ticket. Of respondents given second question, 54% said they would not buy a ticket. In 1 st question, the lost $10 bill is not directly linked to the ticket, so people are willing to buy a new ticket. In 2 nd question, when the ticket is originally purchased, a ticket purchase account was set up, and would be closed after the show ended. In 2 nd question, therefore, the price of an additional ticket is posted to the still open ticket purchase account, so the price of a ticket is now seems to be $20, which many find to be too high a price. 34 Opening and closing accounts In the ticket problem, there was a natural time to close an account. That is when the show is consumed. Once an account is closed, you go back to zero. Other accounts may, however, be somewhat more subtle, for example, saving and investment accounts. Evidence that people avoid closing accounts at a loss: Selling a stock at a loss is painful: disposition effect (to be further discussed). Companies rarely have low negative earnings but often have low positive earnings: They manage earnings either pushing things to low positive Or they take a bath and move to high negative 35 Earnings Management to avoid losses Burgstahler and Dichev 1997 Earnings management to avoid earnings decreases and losses Journal of Accounting and Economics Shen and Chih 2005 Investor protection, prospect theory, and earnings management: an international comparison of the banking industry Journal of Banking and Finance 36
10 The equity premium puzzles Several big puzzles relate to aggregate stock market behavioral finance has partial explanations for some of these puzzles: Equity premium puzzle: stock returns are higher than they should be given risk borne by investors in stock markets Historical (realized) equity premium in U.S. Historically, a well-diversified portfolio of stocks has substantially outperformed fixed income securities. Important to look at real returns which control for inflation effects. Difference between expected equity return and fixedincome return is known as equity premium. This is return for bearing additional risk of stocks relative to bonds or bills What can explain this puzzle? Standard Expected Utility Theory vs Prospect Theory Total nominal return indexes: Total real return indexes: Siegel, J.J.. From "The Future Value of an 1802 Dollar Invested in Different Asset Classes (in nominal terms)," in Stocks for the Long Run 2nd Edition (McGraw Hill, New York, New York), by McGraw-Hill, Inc. All rights reserved. Reproduced by permission Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted 39 to a publicly available website, in whole or in part. Siegel, J.J.. From "The Future Value of an 1802 Dollar Invested in Different Asset Classes (in real terms)," in Stocks for the Long Run 2nd Edition (McGraw Hill, New York, New York), by McGraw-Hill, Inc. All rights reserved. Reproduced by permission Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part. 40
11 Average historical real returns for stocks, bonds and bills Why is the equity risk premium puzzle? Stocks are riskier and therefore should earn higher returns.. But, the equity premium seems too high Theorists have shown that realized equity premium implies an improbably large degree of risk aversion. First, In an economy with reasonable parameters, average return on stock market would be just 0.1% higher than risk-free rate, not 3.9% (or higher) observed in most studies. Siegel, J. J.. From "Average Real Returns (in %) on Stocks, Bonds and Bills," in Stocks for the Long Run, 2nd Edition, 1998 (McGraw Hill, New York, New York) by McGraw-Hill, Inc. All rights reserved. Reproduced by permission Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly available website, in whole or in part Why is the equity risk premium puzzle? Second, based on a typical logarithmic utility function, the coefficient of relative risk aversion is 1.0. The coefficient of relative risk aversion needed to justify the observed equity risk premium would have to be a whopping 30 in order to explain observed returns! Third, recalling prospects and certainty equivalents, consider the following prospect: P1(0.50, $50,000, $100,000) What certainty equivalent, $x, would make someone indifferent between P1 and this $x? For someone with a coefficient of relative risk aversion of 30, $x would need to be $51,209!! 43 What can explain this equity premium puzzle? Benartzi and Thaler (1995) have linked prospect theory to equity premium puzzle. Key is to remember loss aversion (investors hate losing money) and mental accounting (consider how often investors evaluate their portfolios) Intuitively, if you evaluate your position every day, there is a very good chance that by day s end you will have lost money, so you find stocks very risky and unattractive. But if you evaluate stocks once per decade there is a much smaller chance that you will lose money, so you will find stocks not so risky. The loss aversion does not have much effect on you. Benartzi and Thaler (1995), Myopic loss aversion and the equity premium puzzle, the Quarterly Journal of Economics, page
12 What can explain this equity premium puzzle? Loss aversion Benartzi and Thaler assume a loss aversion factor of 2.5. In other words, the loss of $1 is 2.5 times more painful than a gain of $1 is pleasurable. Mental accounting Consider P(0.5, $200, $-100) as an investment where one can make $200 or lose $100. The expected gain is $50, is the risk of the investment worth the potential gain? Or should we just do nothing rather than accept the prospect? V(P) = 0.50(200) (2.5(-100)) = -25 Reject the prospect! 45 What can explain this equity premium puzzle? Mental accounting What if the prospect is allowed to be run twice before the investor carefully notes the results? The possible outcomes for two gambles are $400 (with a probability of 25%), $100 (with a probability of 50%), and -$200 (with a probability of 25. We label it Px V(Px) = 0.25(400) (100) (2.5(-200)) = +25 Note that now a loss is only half as likely (25% vs 50%) to occur. While this person remains loss averse, she is now more willing to take the risk of the investment as long as she evaluate the outcomes two prospects at a time (i.e., looking at her portfolio every two periods). 46 What can explain this equity premium puzzle? QUESTION: Given prospect theory approach, what evaluation period is consistent with historically observed market risk premium? ANSWER: About a year which is logically how often a typical investor gives his portfolio a careful look. Reasons: Tax is paid annually Portfolio assessment and adjustments are often annual Benartzi and Thaler refer to these loss aversion and shorthorizon portfolio evaluation as myopic loss aversion. 47
BEEM109 Experimental Economics and Finance
University of Exeter Recap Last class we looked at the axioms of expected utility, which defined a rational agent as proposed by von Neumann and Morgenstern. We then proceeded to look at empirical evidence
More informationRational theories of finance tell us how people should behave and often do not reflect reality.
FINC3023 Behavioral Finance TOPIC 1: Expected Utility Rational theories of finance tell us how people should behave and often do not reflect reality. A normative theory based on rational utility maximizers
More informationAnswers to chapter 3 review questions
Answers to chapter 3 review questions 3.1 Explain why the indifference curves in a probability triangle diagram are straight lines if preferences satisfy expected utility theory. The expected utility of
More informationCONVENTIONAL FINANCE, PROSPECT THEORY, AND MARKET EFFICIENCY
CONVENTIONAL FINANCE, PROSPECT THEORY, AND MARKET EFFICIENCY PART ± I CHAPTER 1 CHAPTER 2 CHAPTER 3 Foundations of Finance I: Expected Utility Theory Foundations of Finance II: Asset Pricing, Market Efficiency,
More informationMICROECONOMIC THEROY CONSUMER THEORY
LECTURE 5 MICROECONOMIC THEROY CONSUMER THEORY Choice under Uncertainty (MWG chapter 6, sections A-C, and Cowell chapter 8) Lecturer: Andreas Papandreou 1 Introduction p Contents n Expected utility theory
More informationECON 312: MICROECONOMICS II Lecture 11: W/C 25 th April 2016 Uncertainty and Risk Dr Ebo Turkson
ECON 312: MICROECONOMICS II Lecture 11: W/C 25 th April 2016 Uncertainty and Risk Dr Ebo Turkson Chapter 17 Uncertainty Topics Degree of Risk. Decision Making Under Uncertainty. Avoiding Risk. Investing
More informationInvestment Decisions and Negative Interest Rates
Investment Decisions and Negative Interest Rates No. 16-23 Anat Bracha Abstract: While the current European Central Bank deposit rate and 2-year German government bond yields are negative, the U.S. 2-year
More informationARE LOSS AVERSION AFFECT THE INVESTMENT DECISION OF THE STOCK EXCHANGE OF THAILAND S EMPLOYEES?
ARE LOSS AVERSION AFFECT THE INVESTMENT DECISION OF THE STOCK EXCHANGE OF THAILAND S EMPLOYEES? by San Phuachan Doctor of Business Administration Program, School of Business, University of the Thai Chamber
More informationDecision Theory. Refail N. Kasimbeyli
Decision Theory Refail N. Kasimbeyli Chapter 3 3 Utility Theory 3.1 Single-attribute utility 3.2 Interpreting utility functions 3.3 Utility functions for non-monetary attributes 3.4 The axioms of utility
More informationFinancial Literacy and P/C Insurance
Financial Literacy and P/C Insurance Golden Gate CPCU I-Day San Francisco, CA March 6, 2015 Steven N. Weisbart, Ph.D., CLU, Senior Vice President & Chief Economist Insurance Information Institute 110 William
More informationUnit 4.3: Uncertainty
Unit 4.: Uncertainty Michael Malcolm June 8, 20 Up until now, we have been considering consumer choice problems where the consumer chooses over outcomes that are known. However, many choices in economics
More informationReference Dependence Lecture 1
Reference Dependence Lecture 1 Mark Dean Princeton University - Behavioral Economics Plan for this Part of Course Bounded Rationality (4 lectures) Reference dependence (3 lectures) Neuroeconomics (2 lectures)
More informationIntroduction. Two main characteristics: Editing Evaluation. The use of an editing phase Outcomes as difference respect to a reference point 2
Prospect theory 1 Introduction Kahneman and Tversky (1979) Kahneman and Tversky (1992) cumulative prospect theory It is classified as nonconventional theory It is perhaps the most well-known of alternative
More informationSelf Control, Risk Aversion, and the Allais Paradox
Self Control, Risk Aversion, and the Allais Paradox Drew Fudenberg* and David K. Levine** This Version: October 14, 2009 Behavioral Economics The paradox of the inner child in all of us More behavioral
More informationThe Effect of Pride and Regret on Investors' Trading Behavior
University of Pennsylvania ScholarlyCommons Wharton Research Scholars Wharton School May 2007 The Effect of Pride and Regret on Investors' Trading Behavior Samuel Sung University of Pennsylvania Follow
More informationContext Dependent Preferences
Context Dependent Preferences Mark Dean Behavioral Economics G6943 Fall 2016 Context Dependent Preferences So far, we have assumed that utility comes from the final outcome they receive People make choices
More informationRESEARCH OVERVIEW Nicholas Barberis, Yale University July
RESEARCH OVERVIEW Nicholas Barberis, Yale University July 2010 1 This note describes the research agenda my co-authors and I have developed over the past 15 years, and explains how our papers fit into
More informationDepartment of Economics, UCB
Institute of Business and Economic Research Department of Economics, UCB (University of California, Berkeley) Year 2000 Paper E00 287 Diminishing Marginal Utility of Wealth Cannot Explain Risk Aversion
More informationBehavioral Economics (Lecture 1)
14.127 Behavioral Economics (Lecture 1) Xavier Gabaix February 5, 2003 1 Overview Instructor: Xavier Gabaix Time 4-6:45/7pm, with 10 minute break. Requirements: 3 problem sets and Term paper due September
More informationLecture 11: Critiques of Expected Utility
Lecture 11: Critiques of Expected Utility Alexander Wolitzky MIT 14.121 1 Expected Utility and Its Discontents Expected utility (EU) is the workhorse model of choice under uncertainty. From very early
More information8/28/2017. ECON4260 Behavioral Economics. 2 nd lecture. Expected utility. What is a lottery?
ECON4260 Behavioral Economics 2 nd lecture Cumulative Prospect Theory Expected utility This is a theory for ranking lotteries Can be seen as normative: This is how I wish my preferences looked like Or
More informationMaking Hard Decision. ENCE 627 Decision Analysis for Engineering. Identify the decision situation and understand objectives. Identify alternatives
CHAPTER Duxbury Thomson Learning Making Hard Decision Third Edition RISK ATTITUDES A. J. Clark School of Engineering Department of Civil and Environmental Engineering 13 FALL 2003 By Dr. Ibrahim. Assakkaf
More informationPrice Theory Lecture 9: Choice Under Uncertainty
I. Probability and Expected Value Price Theory Lecture 9: Choice Under Uncertainty In all that we have done so far, we've assumed that choices are being made under conditions of certainty -- prices are
More informationJournal Of Financial And Strategic Decisions Volume 10 Number 3 Fall 1997 CORPORATE MANAGERS RISKY BEHAVIOR: RISK TAKING OR AVOIDING?
Journal Of Financial And Strategic Decisions Volume 10 Number 3 Fall 1997 CORPORATE MANAGERS RISKY BEHAVIOR: RISK TAKING OR AVOIDING? Kathryn Sullivan* Abstract This study reports on five experiments that
More informationCHOICE THEORY, UTILITY FUNCTIONS AND RISK AVERSION
CHOICE THEORY, UTILITY FUNCTIONS AND RISK AVERSION Szabolcs Sebestyén szabolcs.sebestyen@iscte.pt Master in Finance INVESTMENTS Sebestyén (ISCTE-IUL) Choice Theory Investments 1 / 65 Outline 1 An Introduction
More informationExpected utility theory; Expected Utility Theory; risk aversion and utility functions
; Expected Utility Theory; risk aversion and utility functions Prof. Massimo Guidolin Portfolio Management Spring 2016 Outline and objectives Utility functions The expected utility theorem and the axioms
More informationEd Westerhout. Netspar Pension Day. CPB, TiU, Netspar. October 13, 2017 Utrecht
Ed Westerhout CPB, TiU, Netspar Netspar Pension Day October 13, 2017 Utrecht Welfare gains from intergenerational risk sharing - Collective db en dc systems Prospect theory - Matches the data better than
More informationChapter 23: Choice under Risk
Chapter 23: Choice under Risk 23.1: Introduction We consider in this chapter optimal behaviour in conditions of risk. By this we mean that, when the individual takes a decision, he or she does not know
More informationBehavioral Economics. Student Presentations. Daniel Kahneman, Thinking, Fast and Slow
Student Presentations Daniel Kahneman, Thinking, Fast and Slow Chapter 26, Prospect Theory The main idea or concept of this chapter: Diminishing Sensitivity When people have different amounts of wealth,
More informationChoice under risk and uncertainty
Choice under risk and uncertainty Introduction Up until now, we have thought of the objects that our decision makers are choosing as being physical items However, we can also think of cases where the outcomes
More informationTECHNIQUES FOR DECISION MAKING IN RISKY CONDITIONS
RISK AND UNCERTAINTY THREE ALTERNATIVE STATES OF INFORMATION CERTAINTY - where the decision maker is perfectly informed in advance about the outcome of their decisions. For each decision there is only
More informationIs Loss Aversion Causing Investors to Shun Equities?
leadership series market perspectives February 2013 Is Loss Aversion Causing Investors to Shun Equities? During the past 13 years, investors have experienced some turbulent episodes, including two of the
More informationKeeping Up with the Joneses Preferences: Asset Pricing Considerations
Keeping Up with the Joneses Preferences: Asset Pricing Considerations Fernando Zapatero Marshall School of Business USC February 2013 Motivation Economics and Finance have developed a series of models
More informationProject Risk Analysis and Management Exercises (Part II, Chapters 6, 7)
Project Risk Analysis and Management Exercises (Part II, Chapters 6, 7) Chapter II.6 Exercise 1 For the decision tree in Figure 1, assume Chance Events E and F are independent. a) Draw the appropriate
More information8/31/2011. ECON4260 Behavioral Economics. Suggested approximation (See Benartzi and Thaler, 1995) The value function (see Benartzi and Thaler, 1995)
ECON4260 Behavioral Economics 3 rd lecture Endowment effects and aversion to modest risk Suggested approximation (See Benartzi and Thaler, 1995) w( p) p p (1 p) 0.61for gains 0.69 for losses 1/ 1 0,9 0,8
More informationUTILITY ANALYSIS HANDOUTS
UTILITY ANALYSIS HANDOUTS 1 2 UTILITY ANALYSIS Motivating Example: Your total net worth = $400K = W 0. You own a home worth $250K. Probability of a fire each yr = 0.001. Insurance cost = $1K. Question:
More informationComparison of Payoff Distributions in Terms of Return and Risk
Comparison of Payoff Distributions in Terms of Return and Risk Preliminaries We treat, for convenience, money as a continuous variable when dealing with monetary outcomes. Strictly speaking, the derivation
More informationEconomics and Portfolio Strategy
Economics and Portfolio Strategy Peter L. Bernstein, Inc. 575 Madison Avenue, Suite 1006 New York, N.Y. 10022 Phone: 212 421 8385 FAX: 212 421 8537 October 15, 2004 SKEW YOU, SAY THE BEHAVIORALISTS 1 By
More informationAmbiguity Aversion. Mark Dean. Lecture Notes for Spring 2015 Behavioral Economics - Brown University
Ambiguity Aversion Mark Dean Lecture Notes for Spring 2015 Behavioral Economics - Brown University 1 Subjective Expected Utility So far, we have been considering the roulette wheel world of objective probabilities:
More informationINSIGHT on the Issues
INSIGHT on the Issues AARP Public Policy Institute The Case for Investing in Bonds During Retirement 1 Creating a financially secure retirement involves not only saving enough, but effectively managing
More informationManagerial Economics
Managerial Economics Unit 9: Risk Analysis Rudolf Winter-Ebmer Johannes Kepler University Linz Winter Term 2015 Managerial Economics: Unit 9 - Risk Analysis 1 / 49 Objectives Explain how managers should
More informationTHE CODING OF OUTCOMES IN TAXPAYERS REPORTING DECISIONS. A. Schepanski The University of Iowa
THE CODING OF OUTCOMES IN TAXPAYERS REPORTING DECISIONS A. Schepanski The University of Iowa May 2001 The author thanks Teri Shearer and the participants of The University of Iowa Judgment and Decision-Making
More informationMicroeconomic Theory III Spring 2009
MIT OpenCourseWare http://ocw.mit.edu 14.123 Microeconomic Theory III Spring 2009 For information about citing these materials or our Terms of Use, visit: http://ocw.mit.edu/terms. MIT 14.123 (2009) by
More informationChapter 15 Trade-offs Involving Time and Risk. Outline. Modeling Time and Risk. The Time Value of Money. Time Preferences. Probability and Risk
Involving Modeling The Value Part VII: Equilibrium in the Macroeconomy 23. Employment and Unemployment 15. Involving Web 1. Financial Decision Making 24. Credit Markets 25. The Monetary System 1 / 36 Involving
More informationCHAPTER 2 RISK AND RETURN: PART I
1. The tighter the probability distribution of its expected future returns, the greater the risk of a given investment as measured by its standard deviation. False Difficulty: Easy LEARNING OBJECTIVES:
More informationManagerial Economics Uncertainty
Managerial Economics Uncertainty Aalto University School of Science Department of Industrial Engineering and Management January 10 26, 2017 Dr. Arto Kovanen, Ph.D. Visiting Lecturer Uncertainty general
More informationComparative Risk Sensitivity with Reference-Dependent Preferences
The Journal of Risk and Uncertainty, 24:2; 131 142, 2002 2002 Kluwer Academic Publishers. Manufactured in The Netherlands. Comparative Risk Sensitivity with Reference-Dependent Preferences WILLIAM S. NEILSON
More informationECE 302 Spring Ilya Pollak
ECE 302 Spring 202 Practice problems: Multiple discrete random variables, joint PMFs, conditional PMFs, conditional expectations, functions of random variables Ilya Pollak These problems have been constructed
More informationECON Microeconomics II IRYNA DUDNYK. Auctions.
Auctions. What is an auction? When and whhy do we need auctions? Auction is a mechanism of allocating a particular object at a certain price. Allocating part concerns who will get the object and the price
More informationReverse Common Ratio Effect
Institute for Empirical Research in Economics University of Zurich Working Paper Series ISSN 1424-0459 Working Paper No. 478 Reverse Common Ratio Effect Pavlo R. Blavatskyy February 2010 Reverse Common
More informationWhat are the additional assumptions that must be satisfied for Rabin s theorem to hold?
Exam ECON 4260, Spring 2013 Suggested answers to Problems 1, 2 and 4 Problem 1 (counts 10%) Rabin s theorem shows that if a person is risk averse in a small gamble, then it follows as a logical consequence
More informationEconomic of Uncertainty
Economic of Uncertainty Risk Aversion Based on ECO 317, Princeton UC3M April 2012 (UC3M) Economics of Uncertainty. April 2012 1 / 16 Introduction 1 Space of Lotteries (UC3M) Economics of Uncertainty. April
More informationSimilar in How to Frame, But Different in What to Choose
Similar in How to Frame, But Different in What to Choose Mei Wang and Paul S. Fischbeck. This study addresses questions about individuals self-framing for health insurance decisions, and whether their
More informationPayoff Scale Effects and Risk Preference Under Real and Hypothetical Conditions
Payoff Scale Effects and Risk Preference Under Real and Hypothetical Conditions Susan K. Laury and Charles A. Holt Prepared for the Handbook of Experimental Economics Results February 2002 I. Introduction
More informationAn Introduction to Behavioral Finance
Topics An Introduction to Behavioral Finance Efficient Market Hypothesis Empirical Support of Efficient Market Hypothesis Empirical Challenges to the Efficient Market Hypothesis Theoretical Challenges
More informationRisk aversion and choice under uncertainty
Risk aversion and choice under uncertainty Pierre Chaigneau pierre.chaigneau@hec.ca June 14, 2011 Finance: the economics of risk and uncertainty In financial markets, claims associated with random future
More informationCHAPTER 2 RISK AND RETURN: Part I
CHAPTER 2 RISK AND RETURN: Part I (Difficulty Levels: Easy, Easy/Medium, Medium, Medium/Hard, and Hard) Please see the preface for information on the AACSB letter indicators (F, M, etc.) on the subject
More informationChapter 18: Risky Choice and Risk
Chapter 18: Risky Choice and Risk Risky Choice Probability States of Nature Expected Utility Function Interval Measure Violations Risk Preference State Dependent Utility Risk-Aversion Coefficient Actuarially
More informationMental-accounting portfolio
SANJIV DAS is a professor of finance at the Leavey School of Business, Santa Clara University, in Santa Clara, CA. srdas@scu.edu HARRY MARKOWITZ is a professor of finance at the Rady School of Management,
More informationFuzzy-Trace Theory & Financial Risk Tolerance. Meghaan Lurtz, Michael Kothakota, CFP, & Dr. S. Heckman, PhD/CFP 2018
Fuzzy-Trace Theory & Financial Risk Tolerance Meghaan Lurtz, Michael Kothakota, CFP, & Dr. S. Heckman, PhD/CFP 2018 Today s Plan Why & Literature Review Theoretical & Study Goals Method & Analysis Results
More informationModels & Decision with Financial Applications Unit 3: Utility Function and Risk Attitude
Models & Decision with Financial Applications Unit 3: Utility Function and Risk Attitude Duan LI Department of Systems Engineering & Engineering Management The Chinese University of Hong Kong http://www.se.cuhk.edu.hk/
More informationRisk Attitude towards Mandatory Retirement Protection in Hong Kong: Why Are Risky Investments More Attractive?
Asian Social Science; Vol. 10, No. 6; 2014 ISSN 1911-2017 E-ISSN 1911-2025 Published by Canadian Center of Science and Education Risk Attitude towards Mandatory Retirement Protection in Hong Kong: Why
More informationMitigating Investor Risk Seeking Behavior in a Down Real Estate Market
Mitigating Investor Risk Seeking Behavior in a Down Real Estate Market Forthcoming in Journal of Behavioral Finance by Michael J. Seiler Professor and Robert M. Stanton Chair of Real Estate Old Dominion
More informationOutline. Simple, Compound, and Reduced Lotteries Independence Axiom Expected Utility Theory Money Lotteries Risk Aversion
Uncertainty Outline Simple, Compound, and Reduced Lotteries Independence Axiom Expected Utility Theory Money Lotteries Risk Aversion 2 Simple Lotteries 3 Simple Lotteries Advanced Microeconomic Theory
More informationMonetary Economics Efficient Markets and Alternatives. Gerald P. Dwyer Fall 2015
Monetary Economics Efficient Markets and Alternatives Gerald P. Dwyer Fall 2015 Readings This lecture, Malkiel Part 3 Next lecture, Cuthbertson, Chapter 6 Behavioral Finance Behavioral finance is not a
More informationEconomic Risk and Decision Analysis for Oil and Gas Industry CE School of Engineering and Technology Asian Institute of Technology
Economic Risk and Decision Analysis for Oil and Gas Industry CE81.9008 School of Engineering and Technology Asian Institute of Technology January Semester Presented by Dr. Thitisak Boonpramote Department
More informationCopyright (C) 2001 David K. Levine This document is an open textbook; you can redistribute it and/or modify it under the terms of version 1 of the
Copyright (C) 2001 David K. Levine This document is an open textbook; you can redistribute it and/or modify it under the terms of version 1 of the open text license amendment to version 2 of the GNU General
More informationBasic Tools of Finance (Chapter 27 in Mankiw & Taylor)
Basic Tools of Finance (Chapter 27 in Mankiw & Taylor) We have seen that the financial system coordinates saving and investment These are decisions made today that affect us in the future But the future
More informationInsurance Demand under Prospect Theory: A Graphical Analysis. by Ulrich Schmidt
Insurance Demand under Prospect Theory: A Graphical Analysis by Ulrich Schmidt No. 1764 March 2012 Kiel Institute for the World Economy, Hindenburgufer 66, 24105 Kiel, Germany Kiel Working Paper No. 1764
More informationPhysician Compensation and the 2002 Nobel Prize in Economics. Jeff Levin-Scherz, MD MBA FACP Senior Consultant Reden and Anders, Ltd June 6-17, 2003
Physician Compensation and the 2002 Nobel Prize in Economics Jeff Levin-Scherz, MD MBA FACP Senior Consultant Reden and Anders, Ltd June 6-17, 2003 jeff.levin-scherz@reden-anders.com Jeff Levin-Scherz
More informationReference Wealth Effects in Sequential Choice
Journal of Risk and Uncertainty, 17:27 47 (1998) 1998 Kluwer Academic Publishers Reference Wealth Effects in Sequential Choice WILLIAM S. NEILSON Department of Economics, Texas A&M University, College
More informationLoss Aversion and Reference Points in Contracts
Loss Aversion and Reference Points in Contracts D.R. Just Steve Wu Paper prepared for presentation at the SCC-76 Meeting, March 31-April 2, 2005, Myrtle Beach, South Carolina Copyright 2005 by D.R. Just
More informationChoice Under Uncertainty (Chapter 12)
Choice Under Uncertainty (Chapter 12) January 6, 2011 Teaching Assistants Updated: Name Email OH Greg Leo gleo[at]umail TR 2-3, PHELP 1420 Dan Saunders saunders[at]econ R 9-11, HSSB 1237 Rish Singhania
More informationRisk Tolerance and Risk Exposure: Evidence from Panel Study. of Income Dynamics
Risk Tolerance and Risk Exposure: Evidence from Panel Study of Income Dynamics Economics 495 Project 3 (Revised) Professor Frank Stafford Yang Su 2012/3/9 For Honors Thesis Abstract In this paper, I examined
More informationNotes 10: Risk and Uncertainty
Economics 335 April 19, 1999 A. Introduction Notes 10: Risk and Uncertainty 1. Basic Types of Uncertainty in Agriculture a. production b. prices 2. Examples of Uncertainty in Agriculture a. crop yields
More informationCasino gambling problem under probability weighting
Casino gambling problem under probability weighting Sang Hu National University of Singapore Mathematical Finance Colloquium University of Southern California Jan 25, 2016 Based on joint work with Xue
More informationMeasuring and Utilizing Corporate Risk Tolerance to Improve Investment Decision Making
Measuring and Utilizing Corporate Risk Tolerance to Improve Investment Decision Making Michael R. Walls Division of Economics and Business Colorado School of Mines mwalls@mines.edu January 1, 2005 (Under
More informationDynamic Decision Making in Agricultural Futures and Options Markets by Fabio Mattos, Philip Garcia and Joost M. E. Pennings
Dynamic Decision Making in Agricultural Futures and Options Markets by Fabio Mattos, Philip Garcia and Joost M. E. Pennings Suggested citation format: Mattos, F., P. Garcia, and J. M. E. Pennings. 2008.
More informationOptimal Taxation : (c) Optimal Income Taxation
Optimal Taxation : (c) Optimal Income Taxation Optimal income taxation is quite a different problem than optimal commodity taxation. In optimal commodity taxation the issue was which commodities to tax,
More informationMicro Theory I Assignment #5 - Answer key
Micro Theory I Assignment #5 - Answer key 1. Exercises from MWG (Chapter 6): (a) Exercise 6.B.1 from MWG: Show that if the preferences % over L satisfy the independence axiom, then for all 2 (0; 1) and
More informationHow I Learned To Stop Worrying And Love Losses. 15 th Annual GIOA Conference March 20-22, 2019
How I Learned To Stop Worrying And Love Losses 15 th Annual GIOA Conference March 20-22, 2019 Benjamin Finkelstein, CFA befinkelstein@cantor.com Cantor Fitzgerald The easy part of public fund investing
More informationCitation for published version (APA): Groot, J. S. D., & Dijkstra, T. K. (1996). Writing covered calls: should it be done? s.n.
University of Groningen Writing covered calls Groot, J.S. de; Dijkstra, Theo IMPORTANT NOTE: You are advised to consult the publisher's version (publisher's PDF) if you wish to cite from it. Please check
More informationPAULI MURTO, ANDREY ZHUKOV
GAME THEORY SOLUTION SET 1 WINTER 018 PAULI MURTO, ANDREY ZHUKOV Introduction For suggested solution to problem 4, last year s suggested solutions by Tsz-Ning Wong were used who I think used suggested
More informationFrom Cashews to The Evolution of Behavioral Economics. Richard H. Thaler NOBEL PRIZE LECTURE DECEMBER 8, 2017
From Cashews to The Evolution of Behavioral Economics Richard H. Thaler NOBEL PRIZE LECTURE DECEMBER 8, 2017 Stories and thought experiments circa 1970s The dinner party. Conundrum: Why were we happy to
More informationECMC49S Midterm. Instructor: Travis NG Date: Feb 27, 2007 Duration: From 3:05pm to 5:00pm Total Marks: 100
ECMC49S Midterm Instructor: Travis NG Date: Feb 27, 2007 Duration: From 3:05pm to 5:00pm Total Marks: 100 [1] [25 marks] Decision-making under certainty (a) [10 marks] (i) State the Fisher Separation Theorem
More informationEconomics 318 Health Economics. Midterm Examination II March 21, 2013 ANSWER KEY
University of Victoria Department of Economics Economics 318 Health Economics Instructor: Chris Auld Midterm Examination II March 21, 2013 ANSWER KEY Instructions. Answer all questions. For multiple choice
More informationStocks as Lotteries: The Implications of Probability Weighting for Security Prices
Stocks as Lotteries: The Implications of Probability Weighting for Security Prices Nicholas Barberis and Ming Huang Yale University and Stanford / Cheung Kong University September 24 Abstract As part of
More informationExpected Utility and Risk Aversion
Expected Utility and Risk Aversion Expected utility and risk aversion 1/ 58 Introduction Expected utility is the standard framework for modeling investor choices. The following topics will be covered:
More informationTotal /20 /30 /30 /20 /100. Economics 142 Midterm Exam NAME Vincent Crawford Winter 2008
1 2 3 4 Total /20 /30 /30 /20 /100 Economics 142 Midterm Exam NAME Vincent Crawford Winter 2008 Your grade from this exam is one third of your course grade. The exam ends promptly at 1:50, so you have
More informationTOPIC: PROBABILITY DISTRIBUTIONS
TOPIC: PROBABILITY DISTRIBUTIONS There are two types of random variables: A Discrete random variable can take on only specified, distinct values. A Continuous random variable can take on any value within
More informationEngineering as Social Experimentation
Engineering as Social Experimentation Engineering/Experimentation Comparison Engineering Objective is to solve problems which often involves: - unknowns - uncertain outcome - monitor, learn from past experiments
More informationSubjective Expected Utility Theory
Subjective Expected Utility Theory Mark Dean Behavioral Economics Spring 2017 Introduction In the first class we drew a distinction betweem Circumstances of Risk (roulette wheels) Circumstances of Uncertainty
More informationPeople avoid actions that create regret and seek actions that cause
M03_NOFS2340_03_SE_C03.QXD 6/12/07 7:13 PM Page 22 CHAPTER 3 PRIDE AND REGRET Q People avoid actions that create regret and seek actions that cause pride. Regret is the emotional pain that comes with realizing
More informationLecture 2! Introduction to Economic Actors: Households and Firms
Lecture 2! Introduction to Economic Actors: Households and Firms Agents/Sectors in Economics! Individual (Household) Firms Private Banks Central Banks The Government Other Countries/Rest of World Today!
More informationStat 6863-Handout 1 Economics of Insurance and Risk June 2008, Maurice A. Geraghty
A. The Psychology of Risk Aversion Stat 6863-Handout 1 Economics of Insurance and Risk June 2008, Maurice A. Geraghty Suppose a decision maker has an asset worth $100,000 that has a 1% chance of being
More informationIntroduction to Economics I: Consumer Theory
Introduction to Economics I: Consumer Theory Leslie Reinhorn Durham University Business School October 2014 What is Economics? Typical De nitions: "Economics is the social science that deals with the production,
More informationSalience and Asset Prices
Salience and Asset Prices Pedro Bordalo Nicola Gennaioli Andrei Shleifer December 2012 1 Introduction In Bordalo, Gennaioli and Shleifer (BGS 2012a), we described a new approach to choice under risk that
More informationChoice under Uncertainty
Chapter 7 Choice under Uncertainty 1. Expected Utility Theory. 2. Risk Aversion. 3. Applications: demand for insurance, portfolio choice 4. Violations of Expected Utility Theory. 7.1 Expected Utility Theory
More informationScenario Analysis and the AMA
Scenario Analysis and the AMA Dr. Eric Rosengren Executive Vice President Federal Reserve Bank of Boston July 19, 2006 Overview Uses for scenarios in the US. Differing tail events yield differing scenarios
More informationKey concepts: Certainty Equivalent and Risk Premium
Certainty equivalents Risk premiums 19 Key concepts: Certainty Equivalent and Risk Premium Which is the amount of money that is equivalent in your mind to a given situation that involves uncertainty? Ex:
More information