A generalization of Pratt–Arrow measure to nonexpected-utility preferences and inseparable probability and utility

A generalization of Pratt–Arrow measure to nonexpected-utility preferences and inseparable probability and utility

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Article ID: iaor20043060
Country: United States
Volume: 49
Issue: 8
Start Page Number: 1089
End Page Number: 1104
Publication Date: Aug 2003
Journal: Management Science
Authors:
Keywords: economics
Abstract:

The Pratt–Arrow measure of local risk aversion is generalized for the n-dimensional state-preference model of choice under uncertainty in which the decision maker may have inseparable subjective probabilities and utilities, unobservable stochastic prior wealth, and/or smooth nonexpected-utility preferences. Local risk aversion is measured by the matrix of derivatives of the decision maker's risk-neutral probabilities, without reference to true subjective probabilities or riskless wealth positions, and comparative risk aversion is measured without requiring agreement on true probabilities. Risk-neutral probabilities and their derivatives are shown to be sufficient statistics for approximately optimal investment and financing decisions in complete markets for contingent claims.

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