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Mathematical Behavioural Finance
Mathematical Behavioural Finance
Xunyu Zhou
University of Oxford
May 2015 @ IPAM
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Mathematical Behavioural Finance
Overview of This Lecture Series
Part 1: Introduction and Background
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Mathematical Behavioural Finance
Overview of This Lecture Series
Part 1: Introduction and Background
Part 2: Portfolio Choice and Quantile Formulation
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Mathematical Behavioural Finance
Overview of This Lecture Series
Part 1: Introduction and Background
Part 2: Portfolio Choice and Quantile Formulation
Part 3: Market Equilibrium and Asset Pricing
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Mathematical Behavioural Finance
Part I: Introduction and Background
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Mathematical Behavioural Finance
1 Expected Utility Theory and Challenges
2 Alternative Theories for Risky Choice
3 Summary and Further Readings
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Section 1
Expected Utility Theory and Challenges
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Expected Utility Theory
Expected Utility Theory (EUT): To evaluate gambles (randomvariables, lotteries) and form preference
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Expected Utility Theory
Expected Utility Theory (EUT): To evaluate gambles (randomvariables, lotteries) and form preference
Foundation laid by von Neumann and Morgenstern (1947)
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Expected Utility Theory
Expected Utility Theory (EUT): To evaluate gambles (randomvariables, lotteries) and form preference
Foundation laid by von Neumann and Morgenstern (1947)
Axiomatic approach: completeness, transivity, continuity andindependence
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Expected Utility Theory
Expected Utility Theory (EUT): To evaluate gambles (randomvariables, lotteries) and form preference
Foundation laid by von Neumann and Morgenstern (1947)
Axiomatic approach: completeness, transivity, continuity andindependence
Behaviour of a rational agent necessarily coincides with thatof an agent who values uncertain payoffs using expectedconcave utility
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Human Judgement Implied by Expected Utility Theory
EUT: Dominant model for decision making under uncertainty,including financial asset allocation
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Human Judgement Implied by Expected Utility Theory
EUT: Dominant model for decision making under uncertainty,including financial asset allocation
Basic tenets of human judgement implied by EUT in thecontext of asset allocation:
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Human Judgement Implied by Expected Utility Theory
EUT: Dominant model for decision making under uncertainty,including financial asset allocation
Basic tenets of human judgement implied by EUT in thecontext of asset allocation:
Frame of problem: Investors’ preference is independent ofhow problem is stated (described, or framed)
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Human Judgement Implied by Expected Utility Theory
EUT: Dominant model for decision making under uncertainty,including financial asset allocation
Basic tenets of human judgement implied by EUT in thecontext of asset allocation:
Frame of problem: Investors’ preference is independent ofhow problem is stated (described, or framed)Source of satisfaction: Investors evaluate assets according tofinal asset positions
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Human Judgement Implied by Expected Utility Theory
EUT: Dominant model for decision making under uncertainty,including financial asset allocation
Basic tenets of human judgement implied by EUT in thecontext of asset allocation:
Frame of problem: Investors’ preference is independent ofhow problem is stated (described, or framed)Source of satisfaction: Investors evaluate assets according tofinal asset positionsAttitude towards risk: Investors are always risk averse(concave utility)
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Human Judgement Implied by Expected Utility Theory
EUT: Dominant model for decision making under uncertainty,including financial asset allocation
Basic tenets of human judgement implied by EUT in thecontext of asset allocation:
Frame of problem: Investors’ preference is independent ofhow problem is stated (described, or framed)Source of satisfaction: Investors evaluate assets according tofinal asset positionsAttitude towards risk: Investors are always risk averse(concave utility)Beliefs about future: Investors are able to objectivelyevaluate probabilities of future returns
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Human Judgement Implied by Expected Utility Theory
EUT: Dominant model for decision making under uncertainty,including financial asset allocation
Basic tenets of human judgement implied by EUT in thecontext of asset allocation:
Frame of problem: Investors’ preference is independent ofhow problem is stated (described, or framed)Source of satisfaction: Investors evaluate assets according tofinal asset positionsAttitude towards risk: Investors are always risk averse(concave utility)Beliefs about future: Investors are able to objectivelyevaluate probabilities of future returns
Neoclassical economics
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Paradoxes/Puzzles with EUT
EUT is systematically violated via experimental work, andchallenged by many paradoxes and puzzles
Allais paradox: Allais (1953)
Ellesberg paradox: Ellesberg (1961)
Friedman and Savage puzzle: Friedman and Savage (1948)
Equity premium puzzle: Mehra and Prescott (1985)
Risk-free rate puzzle: Weil (1989)
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Independence
Frame: the form used to describe a decision problem
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Independence
Frame: the form used to describe a decision problem
Frame independence: form is irrelevant to behaviour
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Independence
Frame: the form used to describe a decision problem
Frame independence: form is irrelevant to behaviour
People can see through all the different ways cash flows mightbe described
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Independence
Frame: the form used to describe a decision problem
Frame independence: form is irrelevant to behaviour
People can see through all the different ways cash flows mightbe described
Frame independence: the foundation of neoclassicaleconomics/finance
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Independence
Frame: the form used to describe a decision problem
Frame independence: form is irrelevant to behaviour
People can see through all the different ways cash flows mightbe described
Frame independence: the foundation of neoclassicaleconomics/finance
Merton Miller: “If you transfer a dollar from your right pocketto your left pocket, you are no wealthier. Franco (Modigliani)and I proved that rigorously”
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 days
![Page 28: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/28.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
![Page 29: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/29.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
I paid reluctantly, on the last day
![Page 30: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/30.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
I paid reluctantly, on the last day
The PCN in UK said:
![Page 31: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/31.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
I paid reluctantly, on the last day
The PCN in UK said:
A penalty £70 is now payable and must be paid in 28 days
![Page 32: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/32.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
I paid reluctantly, on the last day
The PCN in UK said:
A penalty £70 is now payable and must be paid in 28 daysBut ... if you pay in 14 days there is a discount of 50% to £35
![Page 33: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/33.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
I paid reluctantly, on the last day
The PCN in UK said:
A penalty £70 is now payable and must be paid in 28 daysBut ... if you pay in 14 days there is a discount of 50% to £35
I paid immediately ...
![Page 34: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/34.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
I paid reluctantly, on the last day
The PCN in UK said:
A penalty £70 is now payable and must be paid in 28 daysBut ... if you pay in 14 days there is a discount of 50% to £35
I paid immediately ... filled with gratitude and joy
![Page 35: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/35.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Frame Dependence: My Parking Ticket
I got parking tickets in both HK and UK
In HK, the penalty charge notice (PCN) read:
A penalty HK$400 is now payable and must be paid in 14 daysIf you pay after 14 days there is a surcharge of an additionalHK$400
I paid reluctantly, on the last day
The PCN in UK said:
A penalty £70 is now payable and must be paid in 28 daysBut ... if you pay in 14 days there is a discount of 50% to £35
I paid immediately ... filled with gratitude and joy
Behaviour does depend on frame
![Page 36: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/36.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Reference Point: Tough Jobs
Alan Greenspan “The Age of Turbulence” (2007): Choose betweenthe following two job offers
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Reference Point: Tough Jobs
Alan Greenspan “The Age of Turbulence” (2007): Choose betweenthe following two job offers
A: Earn $105,000/year while all your colleagues earn at least$210,000/year
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Reference Point: Tough Jobs
Alan Greenspan “The Age of Turbulence” (2007): Choose betweenthe following two job offers
A: Earn $105,000/year while all your colleagues earn at least$210,000/year
B: Earn $100,000/year while all your colleagues earn at most$50,000/year
![Page 39: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/39.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Reference Point: Tough Jobs
Alan Greenspan “The Age of Turbulence” (2007): Choose betweenthe following two job offers
A: Earn $105,000/year while all your colleagues earn at least$210,000/year
B: Earn $100,000/year while all your colleagues earn at most$50,000/year
B was more popular
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Reference Point: Tough Jobs
Alan Greenspan “The Age of Turbulence” (2007): Choose betweenthe following two job offers
A: Earn $105,000/year while all your colleagues earn at least$210,000/year
B: Earn $100,000/year while all your colleagues earn at most$50,000/year
B was more popular
Reference point: what matters is deviation of wealth
from certain benchmark, not wealth itself
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chance
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chanceB: Win $5,000 with 100% chance
![Page 44: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/44.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chanceB: Win $5,000 with 100% chanceB was more popular
![Page 45: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/45.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chanceB: Win $5,000 with 100% chanceB was more popular
Experiment 2: Choose between
![Page 46: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/46.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chanceB: Win $5,000 with 100% chanceB was more popular
Experiment 2: Choose between
A: Lose $10,000 with 50% chance and $0 with 50% chance
![Page 47: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/47.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chanceB: Win $5,000 with 100% chanceB was more popular
Experiment 2: Choose between
A: Lose $10,000 with 50% chance and $0 with 50% chanceB: Lose $5,000 with 100% chance
![Page 48: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/48.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chanceB: Win $5,000 with 100% chanceB was more popular
Experiment 2: Choose between
A: Lose $10,000 with 50% chance and $0 with 50% chanceB: Lose $5,000 with 100% chanceThis time: A was more popular
![Page 49: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/49.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Risk Aversion vs. Risk Seeking
Experiment 1: Choose between
A: Win $10,000 with 50% chance and $0 with 50% chanceB: Win $5,000 with 100% chanceB was more popular
Experiment 2: Choose between
A: Lose $10,000 with 50% chance and $0 with 50% chanceB: Lose $5,000 with 100% chanceThis time: A was more popular
Risk averse on gains, risk seeking on losses
![Page 50: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/50.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Loss Aversion: Losses Matter More
Paul Samuelson (1963): Choose between
![Page 51: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/51.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Loss Aversion: Losses Matter More
Paul Samuelson (1963): Choose between
A: Win $100,000 with 50% chance and lose $50,000 with50% chance
![Page 52: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/52.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Loss Aversion: Losses Matter More
Paul Samuelson (1963): Choose between
A: Win $100,000 with 50% chance and lose $50,000 with50% chance
B: Don’t take this bet
![Page 53: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/53.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Loss Aversion: Losses Matter More
Paul Samuelson (1963): Choose between
A: Win $100,000 with 50% chance and lose $50,000 with50% chance
B: Don’t take this bet
B was more popular
![Page 54: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/54.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Loss Aversion: Losses Matter More
Paul Samuelson (1963): Choose between
A: Win $100,000 with 50% chance and lose $50,000 with50% chance
B: Don’t take this bet
B was more popular
Loss aversion: pain from a loss is more than joy from a
gain of the same magnitude
![Page 55: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/55.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
![Page 56: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/56.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chance
![Page 57: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/57.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chanceB: Win $50 with 100% chance
![Page 58: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/58.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chanceB: Win $50 with 100% chanceA was more popular
![Page 59: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/59.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chanceB: Win $50 with 100% chanceA was more popular
Experiment 4: Choose between
![Page 60: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/60.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chanceB: Win $50 with 100% chanceA was more popular
Experiment 4: Choose between
A: Lose $50,000 with 0.1% chance
![Page 61: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/61.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chanceB: Win $50 with 100% chanceA was more popular
Experiment 4: Choose between
A: Lose $50,000 with 0.1% chanceB: Lose $50 with 100% chance
![Page 62: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/62.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chanceB: Win $50 with 100% chanceA was more popular
Experiment 4: Choose between
A: Lose $50,000 with 0.1% chanceB: Lose $50 with 100% chanceThis time: B was more popular
![Page 63: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/63.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Probability Distortion (Weighting): Lottery Ticket andInsurance
Experiment 3: Choose between
A: Win $50,000 with 0.1% chanceB: Win $50 with 100% chanceA was more popular
Experiment 4: Choose between
A: Lose $50,000 with 0.1% chanceB: Lose $50 with 100% chanceThis time: B was more popular
Exaggeration of extremely small probabilities of both
winning big and losing big
![Page 64: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/64.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Equity Premium and Risk-Free Rate Puzzles
Equity premium puzzle (Mehra and Prescott 1985): observedequity premium is too high to be explainable by classicalconsumption-based capital asset pricing model (CCAPM)
![Page 65: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/65.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Equity Premium and Risk-Free Rate Puzzles
Equity premium puzzle (Mehra and Prescott 1985): observedequity premium is too high to be explainable by classicalconsumption-based capital asset pricing model (CCAPM)
Mehra and Prescott found historical equity premium of S&P500 for 1889–1978 to be 6.18%, much higher than could bepredicted by EUT-based CCAPM
![Page 66: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/66.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Equity Premium and Risk-Free Rate Puzzles
Equity premium puzzle (Mehra and Prescott 1985): observedequity premium is too high to be explainable by classicalconsumption-based capital asset pricing model (CCAPM)
Mehra and Prescott found historical equity premium of S&P500 for 1889–1978 to be 6.18%, much higher than could bepredicted by EUT-based CCAPMSubsequent empirical studies have confirmed that this puzzle isrobust across different time periods and different countries
![Page 67: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/67.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Equity Premium and Risk-Free Rate Puzzles
Equity premium puzzle (Mehra and Prescott 1985): observedequity premium is too high to be explainable by classicalconsumption-based capital asset pricing model (CCAPM)
Mehra and Prescott found historical equity premium of S&P500 for 1889–1978 to be 6.18%, much higher than could bepredicted by EUT-based CCAPMSubsequent empirical studies have confirmed that this puzzle isrobust across different time periods and different countries
Risk-free rate puzzle (Weil 1989): observed risk-free rate istoo low to be explainable by classical CCAPM
![Page 68: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/68.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Economic Data 1889–1978 (Mehra and Prescott 1985)
Consumption growth riskless return equity premium S&P 500 return
Periods Mean S.D. Mean S.D. Mean S.D. Mean S.D.
1889–1978 1.83 3.57 0.80 5.67 6.18 16.67 6.98 16.54
1889–1898 2.30 4.90 5.80 3.23 1.78 11.57 7.58 10.021899–1908 2.55 5.31 2.62 2.59 5.08 16.86 7.71 17.211909–1918 0.44 3.07 -1.63 9.02 1.49 9.18 -0.14 12.811919–1928 3.00 3.97 4.30 6.61 14.64 15.94 18.94 16.181929–1938 -0.25 5.28 2.39 6.50 0.18 31.63 2.56 27.901939–1948 2.19 2.52 -5.82 4.05 8.89 14.23 3.07 14.671949–1958 1.48 1.00 -0.81 1.89 18.30 13.20 17.49 13.081959–1968 2.37 1.00 1.07 0.64 4.50 10.17 5.58 10.591969–1978 2.41 1.40 -0.72 2.06 0.75 11.64 0.03 13.11
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Mathematical Behavioural Finance
Expected Utility Theory and Challenges
EUT Based Theories
Recall EUT based formulae (single period)
r − rf ≈ αCov(g, r),
1 + rf ≈1+αgβ
where α: relative risk aversion index, g: consumption growthrate, r: equity return rate, rf : risk-free rate, β: discount rate
![Page 70: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/70.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
EUT Based Theories
Recall EUT based formulae (single period)
r − rf ≈ αCov(g, r),
1 + rf ≈1+αgβ
where α: relative risk aversion index, g: consumption growthrate, r: equity return rate, rf : risk-free rate, β: discount rate
Noting β ≤ 1, we have upper bound α ≤rfg if g > 0
![Page 71: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/71.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
EUT Based Theories
Recall EUT based formulae (single period)
r − rf ≈ αCov(g, r),
1 + rf ≈1+αgβ
where α: relative risk aversion index, g: consumption growthrate, r: equity return rate, rf : risk-free rate, β: discount rate
Noting β ≤ 1, we have upper bound α ≤rfg if g > 0
For 1889–1978, g = 1.83%, rf = 0.80%
![Page 72: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/72.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
EUT Based Theories
Recall EUT based formulae (single period)
r − rf ≈ αCov(g, r),
1 + rf ≈1+αgβ
where α: relative risk aversion index, g: consumption growthrate, r: equity return rate, rf : risk-free rate, β: discount rate
Noting β ≤ 1, we have upper bound α ≤rfg if g > 0
For 1889–1978, g = 1.83%, rf = 0.80%So α ≤ 0.80
1.83= 0.44
![Page 73: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/73.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
EUT Based Theories
Recall EUT based formulae (single period)
r − rf ≈ αCov(g, r),
1 + rf ≈1+αgβ
where α: relative risk aversion index, g: consumption growthrate, r: equity return rate, rf : risk-free rate, β: discount rate
Noting β ≤ 1, we have upper bound α ≤rfg if g > 0
For 1889–1978, g = 1.83%, rf = 0.80%So α ≤ 0.80
1.83= 0.44
On the other hand, we have lower bound α ≥r−rfσgσr
![Page 74: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/74.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
EUT Based Theories
Recall EUT based formulae (single period)
r − rf ≈ αCov(g, r),
1 + rf ≈1+αgβ
where α: relative risk aversion index, g: consumption growthrate, r: equity return rate, rf : risk-free rate, β: discount rate
Noting β ≤ 1, we have upper bound α ≤rfg if g > 0
For 1889–1978, g = 1.83%, rf = 0.80%So α ≤ 0.80
1.83= 0.44
On the other hand, we have lower bound α ≥r−rfσgσr
For 1889–1978, r = 6.98%, σg = 3.57%, σr = 16.54%
![Page 75: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/75.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
EUT Based Theories
Recall EUT based formulae (single period)
r − rf ≈ αCov(g, r),
1 + rf ≈1+αgβ
where α: relative risk aversion index, g: consumption growthrate, r: equity return rate, rf : risk-free rate, β: discount rate
Noting β ≤ 1, we have upper bound α ≤rfg if g > 0
For 1889–1978, g = 1.83%, rf = 0.80%So α ≤ 0.80
1.83= 0.44
On the other hand, we have lower bound α ≥r−rfσgσr
For 1889–1978, r = 6.98%, σg = 3.57%, σr = 16.54%
So α ≥ 6.98%−0.80%3.57%×16.54%
= 10.47
![Page 76: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/76.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Puzzles under EUT
Large gap between upper bound of 0.44 and lower bound of10.47: a significant inconsistency between EUT basedCCAPM and empirical findings of a low risk-free rate and ahigh equity premium
![Page 77: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/77.jpg)
Mathematical Behavioural Finance
Expected Utility Theory and Challenges
Puzzles under EUT
Large gap between upper bound of 0.44 and lower bound of10.47: a significant inconsistency between EUT basedCCAPM and empirical findings of a low risk-free rate and ahigh equity premium
Under EUT, a puzzle thus arises: the solution simultaneouslyrequires a small relative risk aversion to account for the lowrisk-free rate and a large relative risk aversion to account forthe high equity premium
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Section 2
Alternative Theories for Risky Choice
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Yaari’s Dual Theory
Preference on random payoff X ≥ 0 represented by (Yaari 1987)
V (X) =
∫
Xd(w ◦ P) :=
∫
∞
0
w(
P(X > x))
dx
where probability weighting (or distortion) w : [0, 1] → [0, 1], ↑,w(0) = 0, w(1) = 1
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Rank Dependence
Assuming w is differentiable:V (X) =
∫∞
0 xd[−w(1 − FX(x))] =∫∞
0 xw′(1− FX(x))dFX (x)
where FX is CDF of X
1− FX(x) ≡ P (X > x) is rank of outcome x of X (thesmaller the rank the more favourable the outcome)
![Page 81: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/81.jpg)
Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Rank Dependence
Assuming w is differentiable:V (X) =
∫∞
0 xd[−w(1 − FX(x))] =∫∞
0 xw′(1− FX(x))dFX (x)
where FX is CDF of X
1− FX(x) ≡ P (X > x) is rank of outcome x of X (thesmaller the rank the more favourable the outcome)
For example, ranks of supremium, median, and infimum of X:0, 1/2, and 1 respectively
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Rank Dependence
Assuming w is differentiable:V (X) =
∫∞
0 xd[−w(1 − FX(x))] =∫∞
0 xw′(1− FX(x))dFX (x)
where FX is CDF of X
1− FX(x) ≡ P (X > x) is rank of outcome x of X (thesmaller the rank the more favourable the outcome)
For example, ranks of supremium, median, and infimum of X:0, 1/2, and 1 respectively
V (X) depends on ranks of random outcomes
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Rank Dependence
Assuming w is differentiable:V (X) =
∫∞
0 xd[−w(1 − FX(x))] =∫∞
0 xw′(1− FX(x))dFX (x)
where FX is CDF of X
1− FX(x) ≡ P (X > x) is rank of outcome x of X (thesmaller the rank the more favourable the outcome)
For example, ranks of supremium, median, and infimum of X:0, 1/2, and 1 respectively
V (X) depends on ranks of random outcomes
Consistent with first-order stochastic dominance:V (X) ≥ V (Y ) if FX(x) ≤ FY (x) ∀x
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Risk Preference Dictated by Weighting
V (X) =∫∞
0 xw′(1− FX(x))dFX (x)
Risk averse when w(·) is convex (overweighing unfavourablepayoffs and underweighing favourable payoffs)
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Risk Preference Dictated by Weighting
V (X) =∫∞
0 xw′(1− FX(x))dFX (x)
Risk averse when w(·) is convex (overweighing unfavourablepayoffs and underweighing favourable payoffs)
Risk seeking when w(·) is concave
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Risk Preference Dictated by Weighting
V (X) =∫∞
0 xw′(1− FX(x))dFX (x)
Risk averse when w(·) is convex (overweighing unfavourablepayoffs and underweighing favourable payoffs)
Risk seeking when w(·) is concave
Simultaneous risk averse and risk seeking when w(·) isinverse-S shaped
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Probability Weighting Functions
Kahneman and Tversky (1992) weighting
w(p) =pγ
(pγ + (1− p)γ)1/γ,
Tversky and Fox (1995) weighting
w(p) =δpγ
δpγ + (1− p)γ,
Prelec (1998) weighting
w(p) = e−δ(− ln p)γ
Jin and Zhou (2008) weighting
w(z) =
yb−a0 keaµ+
(aσ)2
2 Φ(
Φ−1(z)− aσ)
z ≤ 1− z0,
C + kebµ+(bσ)2
2 Φ(
Φ−1(z)− bσ)
z ≥ 1− z0
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Inverse-S Shaped Functions
0 0.2 0.4 0.6 0.8 10
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1
p
w(p
)
Kahneman−Tversky’s distortionTversky−Fox’s distortionPrelec’s distortionJin−Zhou’s distortion
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Quiggin’s Rank-Dependent Utility Theory
Rank-dependent utility theory (RDUT): Quiggin (1982),Schmeidler (1989)
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Quiggin’s Rank-Dependent Utility Theory
Rank-dependent utility theory (RDUT): Quiggin (1982),Schmeidler (1989)
Preference dictated by an RDUT pair (u,w)
∫
u(X)d(w ◦ P) ≡
∫ ∞
0w(
P(
u(X) > x)
)
dx
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Quiggin’s Rank-Dependent Utility Theory
Rank-dependent utility theory (RDUT): Quiggin (1982),Schmeidler (1989)
Preference dictated by an RDUT pair (u,w)
∫
u(X)d(w ◦ P) ≡
∫ ∞
0w(
P(
u(X) > x)
)
dx
Two components
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Quiggin’s Rank-Dependent Utility Theory
Rank-dependent utility theory (RDUT): Quiggin (1982),Schmeidler (1989)
Preference dictated by an RDUT pair (u,w)
∫
u(X)d(w ◦ P) ≡
∫ ∞
0w(
P(
u(X) > x)
)
dx
Two components
A concave (outcome) utility function: individuals dislikemean-preserving spread
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Quiggin’s Rank-Dependent Utility Theory
Rank-dependent utility theory (RDUT): Quiggin (1982),Schmeidler (1989)
Preference dictated by an RDUT pair (u,w)
∫
u(X)d(w ◦ P) ≡
∫ ∞
0w(
P(
u(X) > x)
)
dx
Two components
A concave (outcome) utility function: individuals dislikemean-preserving spreadA (usually assumed) inverse-S shaped (probability) weightingfunction: individuals overweight tails
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Lopes’ SP/A Theory
Security-Potential/Aspiration (SP/A) theory: Lopes (1987)
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Lopes’ SP/A Theory
Security-Potential/Aspiration (SP/A) theory: Lopes (1987)
A dispositional factor and a situational factor to explain riskychoices
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Lopes’ SP/A Theory
Security-Potential/Aspiration (SP/A) theory: Lopes (1987)
A dispositional factor and a situational factor to explain riskychoices
Dispositional factor describes people’s natural tendency toachieving security and exploiting potential
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Lopes’ SP/A Theory
Security-Potential/Aspiration (SP/A) theory: Lopes (1987)
A dispositional factor and a situational factor to explain riskychoices
Dispositional factor describes people’s natural tendency toachieving security and exploiting potentialSituational factor describes people’s responses to specific,immediate needs and opportunities
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Dispositional Factor
Risk-averse motivated by a desire for security
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Dispositional Factor
Risk-averse motivated by a desire for security
Risk-seeking motivated by a desire for potential
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Dispositional Factor
Risk-averse motivated by a desire for security
Risk-seeking motivated by a desire for potential
Lopes applies Yaari’s dual theory to model the dispositionalfactor
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Dispositional Factor
Risk-averse motivated by a desire for security
Risk-seeking motivated by a desire for potential
Lopes applies Yaari’s dual theory to model the dispositionalfactor
V (X) =∫∞
0 w(P(X > x))dx where
w(p) := νpqs+1 + (1− ν)[1− (1− p)qp+1]
with qs, qp > 0 and 0 < ν < 1
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Dispositional Factor
Risk-averse motivated by a desire for security
Risk-seeking motivated by a desire for potential
Lopes applies Yaari’s dual theory to model the dispositionalfactor
V (X) =∫∞
0 w(P(X > x))dx where
w(p) := νpqs+1 + (1− ν)[1− (1− p)qp+1]
with qs, qp > 0 and 0 < ν < 1
The nonlinear transformation zqs+1 reflects the security and1− (1− z)qp+1 reflects the potential
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Situational Factor
Aspiration level is a situational variable that reflects individualcircumstances, opportunities at hand as well as constraintsimposed by the environment
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Situational Factor
Aspiration level is a situational variable that reflects individualcircumstances, opportunities at hand as well as constraintsimposed by the environment
Situational factor turns into the constraint
P(X ≥ A) ≥ α
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Situational Factor
Aspiration level is a situational variable that reflects individualcircumstances, opportunities at hand as well as constraintsimposed by the environment
Situational factor turns into the constraint
P(X ≥ A) ≥ α
A is the aspiration level, 0 < α < 1
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Kahneman and Tversky’s Cumulative Prospect Theory
Cumulative Prospect Theory (CPT): Kahneman and Tversky(1979), Tversky and Kahneman (1992), Nobel wining 2002
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Kahneman and Tversky’s Cumulative Prospect Theory
Cumulative Prospect Theory (CPT): Kahneman and Tversky(1979), Tversky and Kahneman (1992), Nobel wining 2002
Key ingredients
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Kahneman and Tversky’s Cumulative Prospect Theory
Cumulative Prospect Theory (CPT): Kahneman and Tversky(1979), Tversky and Kahneman (1992), Nobel wining 2002
Key ingredients
Reference point or customary wealth (Markowitz 1952)
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Kahneman and Tversky’s Cumulative Prospect Theory
Cumulative Prospect Theory (CPT): Kahneman and Tversky(1979), Tversky and Kahneman (1992), Nobel wining 2002
Key ingredients
Reference point or customary wealth (Markowitz 1952)S-shaped value (utility) function (risk-averse on gains,risk-seeking on losses), steeper on losses than on gains (lossaversion)
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
Kahneman and Tversky’s Cumulative Prospect Theory
Cumulative Prospect Theory (CPT): Kahneman and Tversky(1979), Tversky and Kahneman (1992), Nobel wining 2002
Key ingredients
Reference point or customary wealth (Markowitz 1952)S-shaped value (utility) function (risk-averse on gains,risk-seeking on losses), steeper on losses than on gains (lossaversion)Probability weighting
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
CPT Preference Function
V (X) =∫∞
0 w+
(
P(
u+
(
(X − B)+)
> x))
dx
−∫∞
0 w−
(
P(
u−
(
(X − B)−)
> x))
dx
where
B: reference point in wealth (possibly random)
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
CPT Preference Function
V (X) =∫∞
0 w+
(
P(
u+
(
(X − B)+)
> x))
dx
−∫∞
0 w−
(
P(
u−
(
(X − B)−)
> x))
dx
where
B: reference point in wealth (possibly random)
X: random payoff
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
CPT Preference Function
V (X) =∫∞
0 w+
(
P(
u+
(
(X − B)+)
> x))
dx
−∫∞
0 w−
(
P(
u−
(
(X − B)−)
> x))
dx
where
B: reference point in wealth (possibly random)
X: random payoff
w± : [0, 1] → [0, 1] probability weightings
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
CPT Preference Function
V (X) =∫∞
0 w+
(
P(
u+
(
(X − B)+)
> x))
dx
−∫∞
0 w−
(
P(
u−
(
(X − B)−)
> x))
dx
where
B: reference point in wealth (possibly random)
X: random payoff
w± : [0, 1] → [0, 1] probability weightings
u+(x)1x≥0 − u−(x)1x<0: overall value function
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Mathematical Behavioural Finance
Alternative Theories for Risky Choice
CPT Preference Function
V (X) =∫∞
0 w+
(
P(
u+
(
(X − B)+)
> x))
dx
−∫∞
0 w−
(
P(
u−
(
(X − B)−)
> x))
dx
where
B: reference point in wealth (possibly random)
X: random payoff
w± : [0, 1] → [0, 1] probability weightings
u+(x)1x≥0 − u−(x)1x<0: overall value function
Note: Tversky and Kahneman (1992) used discrete randomvariables
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Mathematical Behavioural Finance
Summary and Further Readings
Section 3
Summary and Further Readings
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Mathematical Behavioural Finance
Summary and Further Readings
Summary
Rationality – foundation of neoclassical economics
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Mathematical Behavioural Finance
Summary and Further Readings
Summary
Rationality – foundation of neoclassical economics
Dominant in economics theory and practice
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Mathematical Behavioural Finance
Summary and Further Readings
Summary
Rationality – foundation of neoclassical economics
Dominant in economics theory and practice
Rationality seriously challenged by paradoxes, experiments,empirical findings, and financial crises
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Mathematical Behavioural Finance
Summary and Further Readings
Summary
Rationality – foundation of neoclassical economics
Dominant in economics theory and practice
Rationality seriously challenged by paradoxes, experiments,empirical findings, and financial crises
Behavioural theories with new risk preferences have emerged
![Page 121: Mathematical Behavioural Financehelper.ipam.ucla.edu/publications/fm2015/fm2015_12879.pdfExpected Utility Theory (EUT): To evaluate gambles (random variables, lotteries) and form preference](https://reader036.vdocuments.net/reader036/viewer/2022071408/60ff9093ca46281e624c3c1d/html5/thumbnails/121.jpg)
Mathematical Behavioural Finance
Summary and Further Readings
Further Readings
D. Ariely. Predictably Irrational, HarperCollins, New York, 2008.
D. Kahneman and A. Tversky. Prospect theory: An analysis of decision under risk, Econometrica,47:263–291, 1979.
L. L. Lopes. Between hope and fear: The psychology of risk, Advances in Experimental Social Psychology,20:255–295, 1987.
H. Markowitz. The utility of wealth, Journal of Political Economy, 60:151–158, 1952.
R. Mehra and E.C. Prescott. The equity premium: A puzzle, Journal of Monetary Economics, 15:145–161,1985.
J. von Neumann and O. Morgenstern. Theory of Games and Economic Behavior, Princeton UniversityPress, Princeton, 1944.
J. Quiggin. A Theory of anticipated utility, Journal of Economic and Behavioral Organization, 3:323–343,1982.
A. Tversky and D. Kahneman. Advances in prospect theory: Cumulative representation of uncertainty,Journal of Risk and Uncertainty, 5:297–323, 1992.
P. Weil. The Equity premium puzzle and the risk free rate puzzle, Journal of Monetary Economics,24:401–421, 1989.
M. E. Yaari. The dual theory of choice under risk, Econometrica, 55(1):95–115, 1987.
X. Zhou. Mathematicalising behavioural finance, Proceedings of the International Congress ofMathematicians, Hyderabad, India, 2010; available at http://people.maths.ox.ac.uk/˜zhouxy/download/img-PDF342002.pdf