Optimal consumption and investment under time-varying relative risk aversion

We consider the continuous time consumption-investment problem originally formalized and solved by Merton in case of constant relative risk aversion. We present a complete solution for the case where relative risk aversion with respect to consumption varies with time, having in mind an investor with age-dependent risk aversion. This provides a new motivation for life-cycle investment rules. We study the optimal consumption and investment rules, in particular in the case where the relative risk aversion with respect to consumption is increasing with age.     

Prediction market prices under risk aversion and heterogeneous beliefs

In this paper, we examine the properties of prediction market prices when risk averse traders have heterogeneous beliefs in state probabilities. We show that the equilibrium state prices equal the mean beliefs of traders about that state if and only if the traders’ common utility function is logarithmic. We also provide a necessary and sufficient condition ensuring that the state prices are systematically below or above the mean beliefs of traders, thus providing a rational explanation to the favorite-longshot bias in prediction markets.     

Endogenous incompleteness of financial markets: The role of ambiguity and ambiguity aversion

Incompleteness of financial markets has been widely questioned in the literature, but traditional research has been mainly focused on the role of transaction costs and asymmetric information in determining such incompleteness. This paper, instead, focuses on agents’ preferences, showing that the introduction of ambiguity and ambiguity aversion may induce investors to restrict their trading to a simpler set of assets, relative to which they are less likely to make errors.     

Feedback trading in exchange-rate markets: Evidence from within and across economic blocks

This paper examines the pattern of autocorrelation of exchange rates in the EU, ASEAN, and NAFTA. We find no feedback trading within blocks among developed financial markets’ currencies, but it exists for less developed financial markets. Across blocks, no feedback trading is found. ASEAN currencies are an exception on both counts. When present, feedback trading is a destabilizing factor, and it takes place during rising volatility. Finally, the prevalence of negative feedback trading suggests that, in spite of the recent addition of new players into the market, such as mutual funds and hedge funds, the foreign exchange market is mainly influenced by informed players and/or central banks which intervene to protect their currencies.     

The Sarbanes-Oxley Act and CEO tenure,turnover, and risk aversion

Using a sample of CEO turnover from 1999 to 2005, we find that CEOs become significantly more risk averse following the passage of the Sarbanes-Oxley Act, SOX. Their increased risk aversion may serve as an explanation for why CEO tenure is not significantly shortened and forced CEO turnover is not more likely post-SOX, as we document in this paper. In addition, we provide evidence that financial restatements have some effects on CEO tenure and the probability of forced CEO turnover. This may be due to intensified monitoring activities by the board and the financial press in the post-SOX era, but we cannot contribute all of it to SOX. In some occasions, SOX seems to weaken the effect of board monitoring on CEO tenure and the effect of firm performance on CEO risk aversion. Though the increased monitoring level post-SOX contribute to the increased CEO risk aversion, little impact is found from the SOX-mandated accuracy and transparency of financial reporting.     

Utility of wealth and relative risk aversion: Operationalization and estimation

Next to expectations, preferences play an important part in explaining individual investment decision making. In contrast with the case of expectations, most financial models do not presuppose homogeneity with respect to preferences, but leave room for variation between individuals. In this article we employ the social filter theory to model the concept of utility. The investor group on which we focus consists of a sample drawn from the members of the Dutch Central Union of Investment Study Clubs. By means of verbal choice behavior we operationalize and determine empirically the utility function of wealth as a function of club-specific characteristics, and we analyze the implications for the corresponding relative risk aversion.We express our gratitude to Jelle Koolstra, who created the dataset with the help of the Dutch Central Union of Investment Study Clubs (NCVB). Programming support by Rob Flik is gratefully acknowledged. We like to thank Gerrit Antonides and Winfried Hallerbach for stimulating discussions on the subject. Responsability for remaining errors is that of the author.     

Optimal securities under adverse selection and moral hazard

We consider project financing under adverse selection and moral hazard and derive several interesting results. First, we provide an explanation of why good firms issue both debt and underpriced equity (even if the bankruptcy and agency costs of debt are zero). Second, we show that, in the presence of moral hazard, adverse selection may induce the conversion of negative into positive NPV projects leading to an improvement in social welfare. Third, we provide a rationale for the use of warrants. We also show that a debt–warrant combination can implement the optimal contract. Our results have a number of testable implications.     

当前我国证券市场监管的现状及对策研究

在整个金融体系中,证券市场占有举足轻重的地位.证券市场的任何动荡都会波及到整个金融系统,并且影响到国家经济的稳定和发展.因此,证券市场的监管尤为重要,科学的监管措施可以有效克制证券市场不足,保护投资者的合法利益,保障证券市场平稳和透明,提高交易效率和证券创新能力,降低风险.文章分析了中国证券市场现行监管体制监管存在的问题,并提出了相应完善我国证券市场监管的对策.     

Variance trading and market price of variance risk

This paper develops a new approach for variance trading. We show that the discretely-sampled realized variance can be robustly replicated under very general conditions, including when the price can jump. The replication strategy specifies the exact timing for rebalancing in the underlying. The deviations from the optimal schedule can lead to surprisingly large hedging errors. In the empirical application, we synthesize the prices of the variance contract on S&P 500 index over the period from 01/1990 to 12/2009. We find that the market variance risk is priced, its risk premium is negative and economically very large. The variance risk premium cannot be explained by the known risk factors and option returns.     

当前我国证券市场监管的现状及对策研究

在整个金融体系中,证券市场占有举足轻重的地位。证券市场的任何动荡都会波及到整个金融系统,并且影响到国家经济的稳定和发展。因此,证券市场的监管尤为重要,科学的监管措施可以有效克制证券市场不足,保护投资者的合法利益,保障证券市场平稳和透明,提高交易效率和证券创新能力,降低风险。文章分析了中国证券市场现行监管体制监管存在的问题,并提出了相应完善我国证券市场监管的对策。     

Relative risk aversion and the transmission of financial crises

We study how investor behavior affects the transmission of financial crises. If investors exhibit decreasing relative risk aversion, then negative wealth shocks increase the risk premium required to hold risky assets. We integrate this into a second generation model of currency crises which allows for contagion through changes in fundamentals. Investor behavior can be a transmission channel of financial crises, as changes in risk premia increase the coverage ratio and makes the defense of a peg less attractive for the policy maker. The feedback effect of the risk premia on the probability of devaluation also makes multiple equilibria more likely. The possible stabilization effects of capital controls and a Tobin tax on the international transmission of financial crises are also studied.     

Informational cascades with endogenous prices: The role of risk aversion

In this paper, we show that long run market informational inefficiency and informational cascades can easily happen when trades occur at market clearing prices. We consider a sequential trade model where: (i) the investors’ set of actions is discrete; (ii) dealers and investors differ in risk aversion; (iii) investors’ information is bounded. We show that informational cascade occurs as soon as traders’ beliefs do not differ too sharply. Thus, prices cannot fully incorporate the private information dispersed in the economy.     

On the relationship between absolute prudence and absolute risk aversion

Abstract For a utility function , the functions and are the Arrow-Pratt coefficient of absolute risk aversion (ara) and the coefficient of absolute prudence (ap). They measure respectively an agent’s sensitivity to risk and the strength of the precautionary saving motive under income uncertainty.     

On compensation for risk aversion and skewness affection in wages

This paper presents extensive empirical testing of the hypothesis that greater post-schooling earnings risk requires higher expected returns. Expanding on this notion, on the basis of utility theory, we predict that workers not only care about risk but also about the skewness in the distribution of the compensation paid: workers exhibit risk aversion and skewness affection. To test these hypotheses, this paper carefully develops various measures of risk and skewness by occupational/educational classification of the worker and finds supportive evidence: for men, wages rise with occupational earnings variance and decrease with skewness, for women only the negative effect of skewness is significant.     

Risk aversion and risk vulnerability in the continuous and discrete case

This paper discusses utility functions for money, where allowable money values are from an arbitrary nonempty closed subset of the real numbers. Thus, the classical case, where this subset is a closed interval (bounded or not) of the real line, is included in the study. The discrete case, where this subset is the set of all integer numbers, is also included. In a sense, the discrete case (which has not been addressed in the literature thus far) is more suitable for real-world applications than the continuous case. In this general setting, the concepts of risk aversion and risk premium are defined, an analogue of Pratt’s fundamental theorem is proved, and temperance, prudence, and risk vulnerability are examined.     

Developments in non-expected utility theories: an empirical study of risk aversion

This paper investigates different developments in non-expected utility theories. Our focus is to study the agent’s attitude towards risk in a context of monetary gambles. Based on simulated data of the “Deal or No Deal” TV game show, we first compare the performance of the expected utility model versus a loss-aversion model. We find that the loss-aversion model has a better performance compared to the expected utility model. We then study the attitude towards risk according to two parameters: the relative risk aversion coefficient defined over the value function and the probability weighting coefficient proposed by the Cumulative Prospect Theory. We find evidence for probability weighting being undertaken by contestants reflecting less risk aversion over large stakes. We also explore the performance of two models of rank-dependant utility: the Quiggin (1982) and the power probability weighting models. We find that the probability weighting coefficient is still significant for both models. Finally, we integrate initial wealth into the contestants’ preferences function and we show that the initial wealth level affects the estimates of risk attitudes.     

Dynamic estimation of volatility risk premia and investor risk aversion from option-implied and realized volatilities

This paper proposes a method for constructing a volatility risk premium, or investor risk aversion, index. The method is intuitive and simple to implement, relying on the sample moments of the recently popularized model-free realized and option-implied volatility measures. A small-scale Monte Carlo experiment confirms that the procedure works well in practice. Implementing the procedure with actual S&P500 option-implied volatilities and high-frequency five-minute-based realized volatilities indicates significant temporal dependencies in the estimated stochastic volatility risk premium, which we in turn relate to a set of macro-finance state variables. We also find that the extracted volatility risk premium helps predict future stock market returns.     

Information markets, product markets and vertical merger

In many markets, firms have the option of advertising at price comparison sites to broaden their market reach. Such sites are often controlled by profit-maximizing “information gatekeepers” charging advertising fees. This paper considers vertical merger between such a monopoly information gatekeeper and a firm in the product market. We find that: (i) If the integrated firm can act as a price leader before independent firms make advertising and pricing decisions, then the merger is profitable. (ii) If the integrated firm cannot move first, then the merger is unprofitable, or divestiture is optimal in the case where the firm has already created the gatekeeper. As a result, the merged entity has an incentive to invest in technologies to support a price leader.     

Aggregate stock market behavior and investors’ low risk aversion

This paper studies whether investors’ high risk aversion can be avoided in a representative-agent model that is able to explain aggregate stock market behavior in the US financial market. We present a consumption-based asset pricing model with a representative agent who has a ‘catching up with the Joneses’ preference to show that high risk aversion can be avoided in a representative-agent model that can help explain many of the empirically observed properties of the aggregate stock market return, including the equity premium and risk-free rate puzzles, the predictability of long-horizon stock returns, and the ‘leverage effect’ in return volatility.