STABILITY OF THE UTILITY MAXIMIZATION PROBLEM WITH RANDOM ENDOWMENT IN INCOMPLETE MARKETS

We perform a stability analysis for the utility maximization problem in a general semimartingale model where both liquid and illiquid assets (random endowments) are present. Small misspecifications of preferences (as modeled via expected utility), as well as views of the world or the market model (as modeled via subjective probabilities) are considered. Simple sufficient conditions are given for the problem to be well posed, in the sense that the optimal wealth and the marginal utility‐based prices are continuous functionals of preferences and probabilistic views.     

Islamic economics and a third fundamental theorem of welfare economics

The discipline of economics started as a moral science but became detached from moral concerns over time to emulate natural science and to adopt positivism. Consequently, mainstream economics assumes people to be sordidly selfish. The teachings of Islam, however, promote social preferences where individuals should be other‐regarding and have preferences over social outcomes. This paper replaces the selfish agent with a social agent and presents the results in a theorem referred to as the third fundamental theorem of welfare economics (TFTWE). The TFTWE states that “when the selfish agents are replaced with the social agents, market outcomes are Pareto optimal, equitable, and unique”. This is an important result which has widespread implications. We show that the TFTWE holds under conditions where the first two fundamental theorems of welfare economics fail and that a Walrasian equilibrium is more likely to exist when selfish preferences are non‐convex. Unlike the popular convention, there is no equity‐efficiency trade‐off. In fact we point to the possibility of reversal in equity‐efficiency trade‐off.     

Comparing stated and realized preferences for shade‐grown vs. conventionally grown coffee

We used both stated preference and revealed preference data to estimate willingness to pay (WTP) for shade‐grown coffee as compared with conventionally grown coffee. Stated preference data was collected using contingent valuation studies. Revealed preference data came from an experiment where all survey participants received a personally identifiable voucher redeemable for a free bakery item when the holder purchased a coffee. We compared estimates of mean and median WTP a price premium for shade‐grown coffee from stated preference data with similar estimates from revealed preference data. We used a logit model to evaluate the effect of explanatory variables (measures of environmental attitudes, personal norms for pro‐environmental behaviour and demographic variables) on respondents’ WTP a price premium for shade grown coffee. Model parameters were estimated using the maximum likelihood approach. Respondents with higher scores on measures of environmental attitudes and personal norms for pro‐environmental behaviour were, on average, willing to pay more for shade‐grown coffee. While this paper examined a specific case, purchase of shade‐grown coffee, our results confirmed that stated environmental concern was a good predictor of pro‐environmental behaviour. We found that mean and median WTP estimates from stated preference methods were higher, but not significantly different than mean and median WTP estimates from actual purchases, indicating convergent validity between stated and realized preference methods. The majority of individuals both stated WTP a price premium and purchased shade‐grown coffee at a price premium. We did, however notice some interesting behaviour at the individual level where stated preferences under‐predicted realized preferences at low price‐premia and over‐predicted realized preferences at high price premia.     

OPTIMAL INSURANCE DESIGN UNDER RANK‐DEPENDENT EXPECTED UTILITY

We consider an optimal insurance design problem for an individual whose preferences are dictated by the rank‐dependent expected utility (RDEU) theory with a concave utility function and an inverse‐S shaped probability distortion function. This type of RDEU is known to describe human behavior better than the classical expected utility. By applying the technique of quantile formulation, we solve the problem explicitly. We show that the optimal contract not only insures large losses above a deductible but also insures small losses fully. This is consistent, for instance, with the demand for warranties. Finally, we compare our results, analytically and numerically, both to those in the expected utility framework and to cases in which the distortion function is convex or concave.     

Convergence of utility indifference prices to the superreplication price in a multiple‐priors framework

This paper formulates a utility indifference pricing model for investors trading in a discrete time financial market under nondominated model uncertainty. Investor preferences are described by possibly random utility functions defined on the positive axis. We prove that when the investors's absolute risk aversion tends to infinity, the multiple‐priors utility indifference prices of a contingent claim converge to its multiple‐priors superreplication price. We also revisit the notion of certainty equivalent for multiple‐priors and establish its relation with risk aversion.     

SENSITIVITY ANALYSIS OF NONLINEAR BEHAVIOR WITH DISTORTED PROBABILITY

In this paper, we propose a sensitivity‐based analysis to study the nonlinear behavior under nonexpected utility with probability distortions (or “distorted utility” for short). We first discover the “monolinearity” of distorted utility, which means that after properly changing the underlying probability measure, distorted utility becomes locally linear in probabilities, and the derivative of distorted utility is simply an expectation of the sample path derivative under the new measure. From the monolinearity property, simulation algorithms for estimating the derivative of distorted utility can be developed, leading to gradient‐based search algorithms for the optimum of distorted utility. We then apply the sensitivity‐based approach to the portfolio selection problem under distorted utility with complete and incomplete markets. For the complete markets case, the first‐order condition is derived and optimal wealth deduced. For the incomplete markets case, a dual characterization of optimal policies is provided; a solvable incomplete market example with unhedgeable interest rate risk is also presented. We expect this sensitivity‐based approach to be generally applicable to optimization problems involving probability distortions.     

Assessing the impact of unilateral trade policies EBA and AGOA on African beneficiaries' exports using matching econometrics

The existing literature studying the impact of non‐reciprocal preferential trade agreements (NRPTAs) assumes implicitly NRPTAs are non‐randomly assigned without showing the evidence of that. Using a matching methodology, this paper investigates whether the “African Growth and Opportunity Act” (AGOA) and the “Everything But Arms” (EBA) unilateral trade concessions have had an impact, and in what magnitude, on the exports of African beneficiary countries in the light of the evidence of the non‐random nature (endogeneity) of NRPTAs. Methodologically, previous studies using the matching procedure focused on bi or multilateral trade agreements. Our work focuses on NRPTAs that depend only on donors' conditions. Accordingly, we show that for NRPTAs, gravity covariates cannot be used for the matching procedure. We propose to use political variables as determinants for obtaining non‐reciprocal trade preferences in order to address the endogenous nature of NRPTA assignment. Our main results confirm that a country becomes eligible for a NRPTA only when it meets certain conditions, defined by their donors, such as political stability and economic regulation (for AGOA), and freedom of expression and human development (for EBA). Results also show that both AGOA and EBA policies have had a positive impact on African beneficiary countries' exports to NRPTA's providers, even if the magnitude impact of EBA is significantly lower than that of AGOA.     

SKEWNESS‐AWARE ASSET ALLOCATION: A NEW THEORETICAL FRAMEWORK AND EMPIRICAL EVIDENCE

This paper presents a new measure of skewness, skewness‐aware deviation, that can be linked to prospective satisficing risk measures and tail risk measures such as Value‐at‐Risk. We show that this measure of skewness arises naturally also when one thinks of maximizing the certainty equivalent for an investor with a negative exponential utility function, thus bringing together the mean‐risk, expected utility, and prospective satisficing measures frameworks for an important class of investor preferences. We generalize the idea of variance and covariance in the new skewness‐aware asset pricing and allocation framework. We show via computational experiments that the proposed approach results in improved and intuitively appealing asset allocation when returns follow real‐world or simulated skewed distributions. We also suggest a skewness‐aware equivalent of the classical Capital Asset Pricing Model beta, and study its consistency with the observed behavior of the stocks traded at the NYSE between 1963 and 2006.     

Searching Pareto Optimal Solutions for the Problem of Forming and Restructuring Coalitions in Multi-Agent Systems

Coordination is one of the fundamental research issues in distributed artificial intelligence and multi-agent systems. Current multi-agent coalition formation methods present two limits: First, computation must be completely restarted when a change occurs. Second, utility functions of the agents are either global or aggregated. We present a new algorithm to cope with these limits. The first part of this paper presents a coalition formation method for multi-agent systems which finds a Pareto optimal solution without aggregating the preferences of the agents. This protocol is adapted to problems requiring coordination by coalition formation, where it is undesirable, or not possible, to aggregate the preferences of the agents. The second part of this paper proposes an extension of this method enabling dynamic restructuring of coalitions when changes occur in the system.     

Monopolistic competition: CES redux?

We study the competitive and reallocation effects of trade opening in monopolistic competition. To this purpose, we generalize the Melitz (2003) setup with heterogeneous firms and fixed and variable trade costs beyond the CES to the case of additively separable utility functions. We find that extensive margin (Melitz-type selection) effects are robust to relaxing the CES assumption. Intensive margin effects (market share reallocations across inframarginal firms) and competitive (markup) effects are instead fragile. An important implication is that measured productivity gains from trade opening are no longer ensured with non-CES preferences. We discuss our results in the light of alternative setups featuring non-additive preferences, strategic interaction and consumers' preference for an ideal variety.     

On Consensus of Group Decision Making with Interval Utility Values and Interval Preference Orderings

Uncertainty is a common phenomenon in our real world. Interval utility values and interval preference orderings are two of the simplest and most convenient tools to describe uncertain preferences in decision making. In this paper, we investigate consensus problems in group decision making with interval utility values and interval preference orderings. We first establish their transformation relations, and give a formula for calculating the association coefficients of individual uncertain preferences and group ones. We then develop a consensus procedure for group decision making with interval utility values and interval preference orderings, which takes interval utility values as the uniform preference representation. This procedure can be reduced to a series of processes for dealing with some special group decision making situations, such as: group decision making with utility values and preference orderings, group decision making with interval utility values, group decision making with interval preference orderings, etc. Finally, we illustrate the applications of the developed procedures with two practical examples.     

Risk management with weighted VaR

This article studies the optimal portfolio selection of expected utility‐maximizing investors who must also manage their market‐risk exposures. The risk is measured by a so‐called weighted value‐at‐risk (WVaR) risk measure, which is a generalization of both value‐at‐risk (VaR) and expected shortfall (ES). The feasibility, well‐posedness, and existence of the optimal solution are examined. We obtain the optimal solution (when it exists) and show how risk measures change asset allocation patterns. In particular, we characterize three classes of risk measures: the first class will lead to models that do not admit an optimal solution, the second class can give rise to endogenous portfolio insurance, and the third class, which includes VaR and ES, two popular regulatory risk measures, will allow economic agents to engage in “regulatory capital arbitrage,” incurring larger losses when losses occur.     

OPTIMAL CONSUMPTION AND PORTFOLIO DECISIONS WITH PARTIALLY OBSERVED REAL PRICES

We consider optimal consumption and portfolio investment problems of an investor who is interested in maximizing his utilities from consumption and terminal wealth subject to a random inflation in the consumption basket price over time. We consider two cases: (i) when the investor observes the basket price and (ii) when he receives only noisy observations on the basket price. We derive the optimal policies and show that a modified Mutual Fund Theorem consisting of three funds holds in both cases. The compositions of the funds in the two cases are the same, but in general the investor's allocations of his wealth into these funds will differ. However, in the particular case when the investor has constant relative risk-aversion (CRRA) utility, his optimal investment allocations into these funds are also the same in both cases.     

EXPLICIT SOLUTIONS OF CONSUMPTION-INVESTMENT PROBLEMS IN FINANCIAL MARKETS WITH REGIME SWITCHING

We consider a consumption and investment problem where the market presents different regimes. An investor taking decisions continuously in time selects a consumption–investment policy to maximize his expected total discounted utility of consumption. The market coefficients and the investor's utility of consumption are dependent on the regime of the financial market, which is modeled by an observable finite-state continuous-time Markov chain. We obtain explicit optimal consumption and investment policies for specific HARA utility functions. We show that the optimal policy depends on the regime. We also make an economic analysis of the solutions, and show that for every investor the optimal proportion to allocate in the risky asset is greater in a "bull market" than in a "bear market." This behavior is not affected by the investor's risk preferences. On the other hand, the optimal consumption to wealth ratio depends not only on the regime, but also on the investor's risk tolerance: high risk-averse investors will consume relatively more in a "bull market" than in a "bear market," and the opposite is true for low risk-averse investors.     

An Integrated Group Decision-Making Method Dealing with Fuzzy Preferences for Alternatives and Individual Judgments for Selection Criteria

Organizations often require decisions to be made by a group, and decision makers often have fuzzy preferences for alternatives and individual judgments when attempting to reach an optimal solution. In order to deal with the fuzziness of preference of decision makers, this paper proposes an integrated fuzzy group decision-making method. This method allows group members to express fuzzy preferences for alternatives and individual judgments for solution selection criteria. It also allowed for the weighting of group members. The method then aggregates these elements into a compromise group decision which is the most acceptable for the group as a whole. This method has been implemented and tested. An example is presented to illustrate the method.     

A Martingale Characterization of Consumption Choices and Hedging Costs with Margin Requirements

This paper examines optimal consumption and investment choices and the cost of hedging contingent claims in the presence of margin requirements or, more generally, of nonlinear wealth dynamics and constraints on the portfolio policies. Existence of optimal policies is established using martingale and duality techniques under general assumptions on the securities' price process and the investor's preferences. As an illustration, explicit solutions are provided for an agent with ‘logarithmic’ utility. A PDE characterization of the cost of hedging a nonnegative path‐independent European contingent claim is also provided.     

Does party identification associate with consumer preferences? Analyzing Finnish consumers in 2009 and 2014

This article examines the association between Finn's political orientation and preferences regarding hedonistic and mundane consumer activities. Data derived from national‐level surveys collected in Finland in 2009 (n=1,202) and 2014 (n=1,351) suggests that political party identification is an important predictor of perceived consumption, even after controlling for the effects of key socio‐demographic factors. In general, supporters of the right‐wing National Coalition Party consider themselves as high‐level consumers more often than the supporters of other political parties do. The results also show that there have been very few temporal changes in the association between party identification and consumption preferences. The effect of party identification is stronger for hedonistic activities than for mundane activities. It is argued that political party identification has similar impact on individual's consumer preferences as other lifestyle and social network factors have. The findings offer us new possibilities for further research addressing consumer activities, and other behavioural correlates of political orientation.     

Children as co‐researchers voicing their preferences in foods and eating: methodological reflections

There is an increasing and sustained interest in participatory research with children. We subscribe to these new perspectives by involving children as co‐researchers investigating their preferences when it comes to foods and eating. The overall aim of the research project Sustainable Eating Children's Way: Promoting Healthy Food Habits among Children 10–12 (Barn som medforskare i matlandskap) is to create an understanding of how children's food habits can develop in healthier and more sustainable ways. The specific aim of this paper was to discuss the methods used in the first phase of the project in order to find an answer to the question: ‘Is it possible to gain a deeper and more nuanced understanding of children's preferences in foods and eating?’ The research process in this project can be looked upon as two parallel processes: the overall one initiated by the senior research team and the one incorporating the children as co‐researchers. The children participating were 10‐year‐olds attending two classes in the fourth grade of a Swedish government‐funded school. We found the children knowledgeable and competent as co‐researchers. Involving children in the research processes and giving them freedom to explore is a promising way of letting their voices be heard in health promotion programmes.     

A GENERAL EQUILIBRIUM MODEL OF A MULTIFIRM MORAL‐HAZARD ECONOMY WITH FINANCIAL MARKETS

We present a general equilibrium model of a moral‐hazard economy with many firms and financial markets, where stocks and bonds are traded. Contrary to the principal‐agent literature, we argue that optimal contracting in an infinite economy is not about a tradeoff between risk sharing and incentives, but it is all about incentives. Even when the economy is finite, optimal contracts do not depend on principals’ risk aversion, but on market prices of risks. We also show that optimal contracting does not require relative performance evaluation, that the second best risk‐free interest rate is lower than that of the first best, and that the second‐best equity premium can be higher or lower than that of the first best. Moral hazard can contribute to the resolution of the risk‐free rate puzzle. Its potential to explain the equity premium puzzle is examined.     

A NOTE ON THE QUANTILE FORMULATION

Many investment models in discrete or continuous‐time settings boil down to maximizing an objective of the quantile function of the decision variable. This quantile optimization problem is known as the quantile formulation of the original investment problem. Under certain monotonicity assumptions, several schemes to solve such quantile optimization problems have been proposed in the literature. In this paper, we propose a change‐of‐variable and relaxation method to solve the quantile optimization problems without using the calculus of variations or making any monotonicity assumptions. The method is demonstrated through a portfolio choice problem under rank‐dependent utility theory (RDUT). We show that this problem is equivalent to a classical Merton's portfolio choice problem under expected utility theory with the same utility function but a different pricing kernel explicitly determined by the given pricing kernel and probability weighting function. With this result, the feasibility, well‐posedness, attainability, and uniqueness issues for the portfolio choice problem under RDUT are solved. It is also shown that solving functional optimization problems may reduce to solving probabilistic optimization problems. The method is applicable to general models with law‐invariant preference measures including portfolio choice models under cumulative prospect theory (CPT) or RDUT, Yaari's dual model, Lopes' SP/A model, and optimal stopping models under CPT or RDUT.