The Traditional Theoretical View of Preference Theory

This paper reviews the State preference theory from a traditional perspective. It explains the model under which the state preference theory and gives rigorous explanations of the assumptions and their normative explanations. The paper goes further to reflect its focus on the state preference framework and also explains the aspects of state prices and their relation to aggregate wealth. The paper gives a technical view of risk neutral valuation in relation to state preference theorem, insights that allows for transforming of the state prices into a common discount factor known as risk neutral probabilities. The paper looks touches on a few criticisms and finally concludes that the model provides an elegant and general framework for the analysis of financial markets and yields a pricing rule for securities. The state preference theory is remarkably acknowledged for providing useful addition knowledge to a financial economist's toolkit and with a basic understanding of financial m...

2002

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Finance Research …, 2004

This paper introduces state dependent utility into the standard Mehra and Prescott [J. Monet. Econ. 15 (1985) 145] economy by allowing the representative agent's coefficient of relative risk aversion to vary with the underlying economy's growth rate. Existence of equilibrium is ...

Canadian Journal of Economics/Revue Canadienne d`Economique, 2005

This paper surveys recent developments in the theory of option pricing. The emphasis is on the interplay between option prices and investors' impatience and their aversion to risk. The traditional view, steeped in the risk-neutral approach to derivative pricing, has been that these preferences play no role in the determination of option prices. However, the usual lognormality assumption required to obtain preference-free option pricing formulas is at odds with the empirical properties of financial assets. The lognormality assumption is easily reconcilable with those properties by the introduction of a latent state variable whose values can be interpreted as the states of the economy. The presence of a covariance risk with the state variable makes option prices depend explicitly on preferences. Generalized option pricing formulas, in which preferences matter, can explain several well-known empirical biases associated with preference-free models such as that of and the stochastic volatility extensions of Hull and White (1987) and Heston (1993).

This paper surveys recent developments in the theory of option pricing. The emphasis is on the interplay between option prices and investors' impatience and their aversion to risk. The traditional view, steeped in the risk-neutral approach to derivative pricing, has been that these preferences play no role in the determination of option prices. However, the usual lognormality assumption required to obtain preference-free option pricing formulas is at odds with the empirical properties of financial assets. The lognormality assumption is easily reconcilable with those properties by the introduction of a latent state variable whose values can be interpreted as the states of the economy. The presence of a covariance risk with the state variable makes option prices depend explicitly on preferences. Generalized option pricing formulas, in which preferences matter, can explain several well-known empirical biases associated with preference-free models such as that of Black and Scholes (...

Review of Financial Studies, 1988

This article investigates the structure onpreferences required to derive Ross's arbitrage pricing theory (APT). It is shown that only ordinalpreferences are required. In particular, the APT does not require that agents possess preferences representable as riskaverse expected utility functions. This characteristic of the APT is not shared by the standard equilibriumbased capital asset pricing models.

Journal of Economics and Business, 2009

Using US market data, this paper sheds new empirical light on properties of the utility function. In particular, employing theoretical relations between Stochastic Discount Factors, state prices, and state probabilities, we are successful in recovering the following four functions: (i) Absolute Risk Aversion (ARA); (ii) Absolute Risk Tolerance (ART); (iii) Absolute Prudence (AP); and (iv) Absolute Temperance (AT). Our statistical analysis points out, unequivocally, that the ARA function is decreasing and convex, the ART function is convex, AT is greater than ARA, and the AP function is not decreasing. These empirical results are analyzed in light of established theory concerning, inter-alia, precautionary saving and prudence as well as the way risk attitudes are affected by the presence of "background risks" and by investors' investment horizon. discuss the recoverability of preferences from observed asset prices and an agent's consumption choice. Jackwerth is the first to use estimates of state prices and physical probabilities to recover A RA functions. We extend on that by characterizing additional properties of the vNM utility function, and relying on a more general approach for estimating state probabilities. Our approach is shown to have non-trivial consequences.

SSRN Electronic Journal, 2013

Matching the first two moments of real returns, real risk free rate and real consumption per capita growth as well as the real per capita consumption growth serial correlation, I find that a mixed risk averse representative agent best explains equity premium historical data. Calibration results suggest both relative risk aversion and elasticity of intertemporal substitution are countercyclical. In addition, the stochastic discount factor varies significantly across states and satisfies the Hansen-Jagannathan bound. Besides, its values match their counterparts implied by data. The aforementioned results are robust to changing the country being investigated and the subjective discount factor value.

Decision Sciences, 1992

Most models of investor behavior assume a time-state independent utility function and result in a deterministic solution where a given set of inputs uniquely specifies the decision. In contrast, a state preference model using a time-state dependent utility function is derived in this paper. The model allows the investment choice decision to be analyzed in a game theontic context. The general solution is a mixed strategy which allows for a probabilistic interpretation of the decision. The approach presented in this paper can accommodate anomalies such as intransitivity of preference and satisficing as rational behavior. An example of a possible implementation is given along with interpretations of the outcomes.

2011

We present results from the first large-scale international survey on risk preferences, conducted in 45 countries. We show substantial cross-country differences in risk aversion, loss aversion and probability weighting. Moreover, risk attitudes in our sample depend not only on economic conditions, but also on cultural factors, as measured by the Hofstede dimensions Individuality and Uncertainty Avoidance. The presented data might also serve as an interesting starting point for further research in cultural economics.