This paper analyzes optimal risk sharing among agents that are endowed with either expected utility preferences or with dual utility preferences. We find that Pareto optimal risk redistributions and the competitive equilibria are obtained via bargaining with a hypothetical representative agent of expected utility maximizers and a hypothetical representative agent of dual utility maximizers. The representative agent of expected utility maximizers resembles an average risk-averse agent, whereas representative agent of dual utility maximizers resembles an agent that has lowest aversion to mean-preserving spreads. This bargaining leads to an allocation of the aggregate risk to both groups of agents. The optimal contract for the expected utility maximizers is proportional to their allocated risk, and the optimal contract for the dual utility maximizing agents is given by "tranching" of their allocated risk. We show a method to derive the equilibrium prices. We identify a condition under which prices are locally independent of the expected utility functions, and given in closed form. Moreover, we characterize uniqueness of the competitive equilibrium.
{"title":"Risk Sharing with Expected and Dual Utilities","authors":"T. Boonen","doi":"10.2139/ssrn.2714395","DOIUrl":"https://doi.org/10.2139/ssrn.2714395","url":null,"abstract":"This paper analyzes optimal risk sharing among agents that are endowed with either expected utility preferences or with dual utility preferences. We find that Pareto optimal risk redistributions and the competitive equilibria are obtained via bargaining with a hypothetical representative agent of expected utility maximizers and a hypothetical representative agent of dual utility maximizers. The representative agent of expected utility maximizers resembles an average risk-averse agent, whereas representative agent of dual utility maximizers resembles an agent that has lowest aversion to mean-preserving spreads. This bargaining leads to an allocation of the aggregate risk to both groups of agents. The optimal contract for the expected utility maximizers is proportional to their allocated risk, and the optimal contract for the dual utility maximizing agents is given by \"tranching\" of their allocated risk. We show a method to derive the equilibrium prices. We identify a condition under which prices are locally independent of the expected utility functions, and given in closed form. Moreover, we characterize uniqueness of the competitive equilibrium.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"35 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2017-03-10","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"128683661","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Law and economics are both hostile to liability in tort for exposure to risk in the absence of actual harm. Actual harm is a fundamental requirement of tort law. Economics teaches that adequate compensation in the event of harm eliminates risk, obviating the need for compensation for mere exposure. I show that if there is risk that compensation will fail to equal the value of the loss, as must always be the case, then, under plausible assumptions about the probability distribution of compensation, compensation for exposure to risk in the absence of harm is required to make a victim whole. The result applies to all measurable harms.
{"title":"Liability for Exposure to Risk without Actual Harm","authors":"Ramsi Woodcock","doi":"10.2139/ssrn.2896359","DOIUrl":"https://doi.org/10.2139/ssrn.2896359","url":null,"abstract":"Law and economics are both hostile to liability in tort for exposure to risk in the absence of actual harm. Actual harm is a fundamental requirement of tort law. Economics teaches that adequate compensation in the event of harm eliminates risk, obviating the need for compensation for mere exposure. I show that if there is risk that compensation will fail to equal the value of the loss, as must always be the case, then, under plausible assumptions about the probability distribution of compensation, compensation for exposure to risk in the absence of harm is required to make a victim whole. The result applies to all measurable harms.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"107 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2017-03-03","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"124129270","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Most market participants are risk adverse and people tend to close their long positions once they perceive a formation of downturn in the market. Large sudden price drops can always be observed near the end of uptrends. On the other hand, people tend to have their own preferences in deciding the market entrance timings and large sudden price changes are relatively less commonly observed near the end of downtrends. Typical Moving Average strategies employ the same approach, using a single pair of time series, to locate the ending points of uptrends and downtrends. This approach does not consider the asymmetry of price changes near the end of uptrend and downtrend distinctively. To cater for the differences, a new approach using distinct pairs of time series for locating uptrends and downtrends is proposed.Performance of the proposed strategy is evaluated using stock market index series from 8 different developed countries including US, UK, Australia, Germany, Canada, Japan, Hong Kong and Singapore under 3 moving average calculation methods. The empirical results indicate that the proposed strategy outperforms the typical strategy and the buy-and-hold strategy. Recommended heuristics for selecting an appropriate MA length will also be addressed in this study.
{"title":"Asymmetry between Uptrend and Downtrend Identification: A Tale of Moving Average Trading Strategy","authors":"C. F. Chu","doi":"10.2139/ssrn.2903855","DOIUrl":"https://doi.org/10.2139/ssrn.2903855","url":null,"abstract":"Most market participants are risk adverse and people tend to close their long positions once they perceive a formation of downturn in the market. Large sudden price drops can always be observed near the end of uptrends. On the other hand, people tend to have their own preferences in deciding the market entrance timings and large sudden price changes are relatively less commonly observed near the end of downtrends. Typical Moving Average strategies employ the same approach, using a single pair of time series, to locate the ending points of uptrends and downtrends. This approach does not consider the asymmetry of price changes near the end of uptrend and downtrend distinctively. To cater for the differences, a new approach using distinct pairs of time series for locating uptrends and downtrends is proposed.Performance of the proposed strategy is evaluated using stock market index series from 8 different developed countries including US, UK, Australia, Germany, Canada, Japan, Hong Kong and Singapore under 3 moving average calculation methods. The empirical results indicate that the proposed strategy outperforms the typical strategy and the buy-and-hold strategy. Recommended heuristics for selecting an appropriate MA length will also be addressed in this study.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"39 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2017-01-23","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"133256446","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
A large strand of research has identified when (i) a single risk is undesirable and (ii) two independent risks aggravate each other. We extend this line of inquiry by establishing when (iii) mutual aggravation is greater for greater risks. This natural property of greater mutual aggravation explains recent experimental findings on higher-order risk preferences, and can guide managerial behavior when risks in the decision environment become more severe. The online appendix is available at https://doi.org/10.1287/mnsc.2017.2746. This paper was accepted by Han Bleichrodt, decision analysis.
{"title":"Greater Mutual Aggravation","authors":"S. Ebert, Diego C. Nocetti, H. Schlesinger","doi":"10.2139/ssrn.2712627","DOIUrl":"https://doi.org/10.2139/ssrn.2712627","url":null,"abstract":"A large strand of research has identified when (i) a single risk is undesirable and (ii) two independent risks aggravate each other. We extend this line of inquiry by establishing when (iii) mutual aggravation is greater for greater risks. This natural property of greater mutual aggravation explains recent experimental findings on higher-order risk preferences, and can guide managerial behavior when risks in the decision environment become more severe. The online appendix is available at https://doi.org/10.1287/mnsc.2017.2746. This paper was accepted by Han Bleichrodt, decision analysis.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"8 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2017-01-06","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"129571458","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
This paper was inspired by "Rational Decision-Making Under Uncertainty: Observed Betting Patterns on a Biased Coin" (Haghani, Victor and Dewey, Richard, https://ssrn.com/abstract=2856963). It derives optimal strategy for a game with known payouts and probability, but uncertain limits on total payout and number of betting opportunities. It further develops some general gambling principles applicable to practical risk taking situations in which all parameters are uncertain and robust approximate simple solutions are required.
{"title":"Optimal Betting Strategy with Uncertain Payout and Opportunity Limits","authors":"Aaron C Brown","doi":"10.2139/ssrn.2947863","DOIUrl":"https://doi.org/10.2139/ssrn.2947863","url":null,"abstract":"This paper was inspired by \"Rational Decision-Making Under Uncertainty: Observed Betting Patterns on a Biased Coin\" (Haghani, Victor and Dewey, Richard, https://ssrn.com/abstract=2856963). It derives optimal strategy for a game with known payouts and probability, but uncertain limits on total payout and number of betting opportunities. It further develops some general gambling principles applicable to practical risk taking situations in which all parameters are uncertain and robust approximate simple solutions are required.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"13 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-12-08","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"129307168","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We study the effect of education on time preference, focusing on Indonesia. Using IndonesiaFamily Life Survey (IFLS) wave 4 and 5, we document the causal effects of education on patience. We apply household fixed effect (FE), sibling FE, individual FE and instrument variable specifications. We use INPRES primary school construction program between 1973/4 and 1978 as an IV for the years of schooling. We find that one more year of schooling makes people more patient by 13.5 percentage point for female in the IV estimation. Our results are robust to the other FE specifications. We also provide the suggestive mechanisms through which education affects patience. Cognition measured by Raven’s test, total income and risk averseness are the plausible mechanisms. Education makes people more cognitively active, richer and risk averse, leading to more patience.
{"title":"Does Education Affect Time Preference?","authors":"Tushar Bharati, Seungwoo Chin, Dawoon Jung","doi":"10.2139/ssrn.2880879","DOIUrl":"https://doi.org/10.2139/ssrn.2880879","url":null,"abstract":"We study the effect of education on time preference, focusing on Indonesia. Using IndonesiaFamily Life Survey (IFLS) wave 4 and 5, we document the causal effects of education on patience. We apply household fixed effect (FE), sibling FE, individual FE and instrument variable specifications. We use INPRES primary school construction program between 1973/4 and 1978 as an IV for the years of schooling. We find that one more year of schooling makes people more patient by 13.5 percentage point for female in the IV estimation. Our results are robust to the other FE specifications. We also provide the suggestive mechanisms through which education affects patience. Cognition measured by Raven’s test, total income and risk averseness are the plausible mechanisms. Education makes people more cognitively active, richer and risk averse, leading to more patience.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"82 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-12-05","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"123656633","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Concepts of utility and optimizing expected incremental utility are ubiquitous in economics, and also in the academic literature of gambling. However, we have been surprised how little these concepts have impacted real-world finance, despite in many cases providing tools which are both helpful and practical. This seems especially odd given the finance and investment world’s ostensible focus on risk management and risk-adjusted returns. We seek to explain how the concept of utility is both central and practical, and how tools arising from maximizing expected incremental utility are central to the important question of investment sizing.
{"title":"Practical Utility, Risk Aversion, and Investment Sizing","authors":"James White","doi":"10.2139/ssrn.2867255","DOIUrl":"https://doi.org/10.2139/ssrn.2867255","url":null,"abstract":"Concepts of utility and optimizing expected incremental utility are ubiquitous in economics, and also in the academic literature of gambling. However, we have been surprised how little these concepts have impacted real-world finance, despite in many cases providing tools which are both helpful and practical. This seems especially odd given the finance and investment world’s ostensible focus on risk management and risk-adjusted returns. We seek to explain how the concept of utility is both central and practical, and how tools arising from maximizing expected incremental utility are central to the important question of investment sizing.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"10 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-11-16","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"114371608","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
Previous research has documented a behavioral distinction between “social risk,” or risk caused by human factors, and natural risk. In particular, people tend to demand a premium on the probability of a favorable outcome in order to expose themselves to a social source of risk rather than a natural source of risk. Several explanations for what drives this social risk premium have been offered—most prominently, (i)an aversion to a counterparty’s potentially malign intentions and (ii) a more general aversion to ceding control to someone with conflicting interests. We propose that a fundamental determinant of the social risk premium may relate to a counterparty’s capacity to engage in intentional action. We employ a between-subjects experimental design in which we manipulate subjects’ capacity for intentional action. Our design allows us to identify the component of the social risk premium related to an aversion to betrayal, independent of any aversion to ceding control. Furthermore, our results show that in...
{"title":"Social Risk and the Dimensionality of Intentions","authors":"Jeffrey V. Butler, J. Miller","doi":"10.1287/mnsc.2016.2694","DOIUrl":"https://doi.org/10.1287/mnsc.2016.2694","url":null,"abstract":"Previous research has documented a behavioral distinction between “social risk,” or risk caused by human factors, and natural risk. In particular, people tend to demand a premium on the probability of a favorable outcome in order to expose themselves to a social source of risk rather than a natural source of risk. Several explanations for what drives this social risk premium have been offered—most prominently, (i)an aversion to a counterparty’s potentially malign intentions and (ii) a more general aversion to ceding control to someone with conflicting interests. We propose that a fundamental determinant of the social risk premium may relate to a counterparty’s capacity to engage in intentional action. We employ a between-subjects experimental design in which we manipulate subjects’ capacity for intentional action. Our design allows us to identify the component of the social risk premium related to an aversion to betrayal, independent of any aversion to ceding control. Furthermore, our results show that in...","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"45 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-10-22","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"132476757","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
I study the incentives and performance of CDO collateral managers, asset management firms responsible for the selection of collateral in ABS CDOs that figured prominently in the 2007-2008 financial crisis. Specialized asset managers with few reputational concerns invest in riskier collateral and gain market share at the expense of more diversified investment managers. Controlling for observable deal characteristics, the IRR of specialized managers' CDOs is 5.8% lower. The results cannot be explained by greater optimism or lower expertise of specialized managers. Deals of specialized managers have smaller equity tranches and invest in higher yielding collateral securities from more recent vintages. This collateral suffers significantly larger losses, even controlling for at-issuance rating and spread. The results point to greater risk taking incentives as one downside of specialization in asset management.
{"title":"The Front Men of Wall Street:The Role of CDO Collateral Managers in the CDO Boom and Bust","authors":"S. Chernenko","doi":"10.2139/ssrn.2629137","DOIUrl":"https://doi.org/10.2139/ssrn.2629137","url":null,"abstract":"I study the incentives and performance of CDO collateral managers, asset management firms responsible for the selection of collateral in ABS CDOs that figured prominently in the 2007-2008 financial crisis. Specialized asset managers with few reputational concerns invest in riskier collateral and gain market share at the expense of more diversified investment managers. Controlling for observable deal characteristics, the IRR of specialized managers' CDOs is 5.8% lower. The results cannot be explained by greater optimism or lower expertise of specialized managers. Deals of specialized managers have smaller equity tranches and invest in higher yielding collateral securities from more recent vintages. This collateral suffers significantly larger losses, even controlling for at-issuance rating and spread. The results point to greater risk taking incentives as one downside of specialization in asset management.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"22 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-10-18","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"131271332","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
We consider a security design problem where public information about the security’s underlying cash-flow arrives between trading periods. The optimal security minimizes less-than-full realization of gains from trade due to limited cash in the market, which may depend on the interim information. We show that the optimal security can be expressed as a convex combination of securities solving minimization problems for which the solutions share many debt-like features but exhibit endogenous tranching. We provide conditions for the non-optimality of standard debt contracts and show that implementation of the class of optimal securities can be achieved by mezzanine tranche retention, providing a public information rationale for departure from the pecking order.
{"title":"Security Design with Interim Public Information","authors":"André Stenzel","doi":"10.2139/ssrn.2229688","DOIUrl":"https://doi.org/10.2139/ssrn.2229688","url":null,"abstract":"We consider a security design problem where public information about the security’s underlying cash-flow arrives between trading periods. The optimal security minimizes less-than-full realization of gains from trade due to limited cash in the market, which may depend on the interim information. We show that the optimal security can be expressed as a convex combination of securities solving minimization problems for which the solutions share many debt-like features but exhibit endogenous tranching. We provide conditions for the non-optimality of standard debt contracts and show that implementation of the class of optimal securities can be achieved by mezzanine tranche retention, providing a public information rationale for departure from the pecking order.","PeriodicalId":281936,"journal":{"name":"ERN: Other Microeconomics: Decision-Making under Risk & Uncertainty (Topic)","volume":"33 1","pages":"0"},"PeriodicalIF":0.0,"publicationDate":"2016-10-10","publicationTypes":"Journal Article","fieldsOfStudy":null,"isOpenAccess":false,"openAccessPdf":"","citationCount":null,"resultStr":null,"platform":"Semanticscholar","paperid":"134368590","PeriodicalName":null,"FirstCategoryId":null,"ListUrlMain":null,"RegionNum":0,"RegionCategory":"","ArticlePicture":[],"TitleCN":null,"AbstractTextCN":null,"PMCID":"","EPubDate":null,"PubModel":null,"JCR":null,"JCRName":null,"Score":null,"Total":0}
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