The cyclicality of bank regulation in a general economic framework

This article utilizes a representative agent model to address how the regulation policies for banks should respond to the general economic condition. With the consideration of a self-fulfilling deposit insurance facility with sufficient bank reserve to meet the expected need of liquidity shock, our model suggests a counter-cyclical capital adequacy requirement in a competitive loan market. The exception might occur when the moral hazard problem becomes very unwieldy and the representative individual is rather risk averse. With regard to the closure policy, we find that it is closely related to the individual’s degree of risk aversion. A counter-cyclical closure policy is recommended when the individual is highly risk averse. Otherwise, a pro-cyclical closure policy is preferred.     

Risk Preferences and Environmental Uncertainty: Implications for Crop Diversification Decisions in Ethiopia

To the extent that diversifying income portfolio is used as a strategy for shielding against production risk, both individual risk aversion and weather uncertainty could affect crop diversification decisions. This paper is concerned with empirically assessing the effects of risk aversion and rainfall variability on farm level diversity. Unique panel data from Ethiopia consisting of experimentally generated risk aversion measures combined with rainfall data are employed in the analysis. The major contribution of this study is its explicit treatment of individual risk preferences in the decision to diversify, simultaneously controlling for environmental risk in the form of rainfall variability. Covariate shocks from rainfall variability are found to positively contribute to an increased level of diversity with individual risk aversion having a positive but less significant role. We find that rainfall variability in spring has a greater effect than rainfall variability summer??the major rainy season. This finding is in line with similar agronomic-meteorological studies. These results imply that in situ biodiversity conservation could be effective in areas with high rainfall variability. However, reduction in risk aversion, which is associated with poverty reduction, is likely to reduce in situ conservation.     

Attitudes to risk and attitudes to uncertainty: experimental evidence

In a series of experiments the interactions among individual attitudes towards risk and uncertainty, the sign of the outcome domain, and the way uncertainty is represented are tested. This is done in a unified framework, eliciting individual values by means of a second price auction. Results confirm the presence of the well-known fourfold pattern of risk attitude (risk aversion for gains and risk seeking for losses at high probability, and risk seeking for gains and risk aversion for losses at low probability) and show that this pattern can also be extended to uncertainty. In the valuation of losses the modal pattern is decreasing risk and uncertainty aversion as the probability of loss increases, while increasing risk and uncertainty aversion is observed for gains. Moreover, it is found that the size of reaction to uncertainty does not depend on the outcome domain, and that it persists in the face of an incentive-compatible mechanism to elicit preferences.     

Monotone risk aversion

Summary. This paper defines decreasing absolute risk aversion in purely behavioral terms without any assumption of differentiability and shows that a strictly increasing and risk averse utility function with decreasing absolute risk aversion is necessarily differentiable with an absolutely continuous derivative. A risk averse utility function has decreasing absolute risk aversion if and only if it has a decreasing absolute risk aversion density, and if and only if the cumulative absolute risk aversion function is increasing and concave. This leads to a characterization of all such utility functions. Analogues of these results also hold for increasing absolute and for increasing and decreasing relative risk aversion.Received: 31 January 2003, Revised: 15 January 2004, JEL Classification Numbers: D81.The views, thoughts and opinions expressed in this paper are those of the author in his individual capacity and should not in any way be attributed to Morgan Stanley or to Lars Tyge Nielsen as a representative, officer, or employee of Morgan Stanley.     

Background risk and the demand for state-contingent claims

Summary. We consider the demand for state-contingent claims, in the presence of an independent zero-mean, non-hedgeable background risk. An agent is defined to be generalized risk averse if he/she chooses a demand function for contingent claims with a smaller slope everywhere, given a simple increase in background risk. We show that the conditions for standard risk aversion, that is positive, declining absolute risk aversion and prudence, are necessary and sufficient for generalized risk aversion.Received: 13 February 2002, Revised: 10 February 2003, JEL Classification Numbers: D52, D81, G11. Correspondence to: Guenter FrankeWe are grateful to Louis Eeckhoudt, Christian Gollier, Harris Schlesinger and an unknown referee for valuable comments.     

Risk aversion and incentive compatibility with ex post information asymmetry

Summary. The paper extends Diamond's (1984) analysis of financial contracting with information asymmetry ex post and endogenous “bankruptcy penalties” to allow for risk aversion of the borrower. The optimality of debt contracts, which Diamond obtained for the case of risk neutrality, is shown to be nonrobust to the introduction of risk aversion. This contrasts with the costly state verification literature, in which debt contracts are optimal for risk averse as well as risk neutral borrowers. Received: December 7, 1998; revised version: June 9, 1999     

The role of corruption and risk aversion in entrepreneurial intentions

The literature on entrepreneurship has suggested that an individual’s entrepreneurial intention depends on three types of factor: personal characteristics, the individual’s expertise and professional background, and external factors. Our study investigates how corruption, an external factor, and risk aversion, a personal characteristic, may simultaneously affect individuals’ entrepreneurial intentions. With data on 76 203 individuals in 53 countries, our estimation results indicate that risk aversion decreases the individual’s probability of having an entrepreneurial intention by 6.67 percentage points. In addition, an increase in 1 SD in the perceived level of corruption in a country decreases the individual’s probability of having an entrepreneurial intention by 0.96 percentage points.     

The Impact of Regret on Exports

We examine optimal production and export decisions of a firm facing exchange rate uncertainty, where the firm's management is not only risk averse but also regret averse, i.e., is characterized by a utility function that includes disutility from having chosen ex post suboptimal alternatives. Experimental and empirical results support the view that managers tend to be regret averse. Under regret aversion a negative risk premium need not preclude the firm from exporting which would be the case if the firm were only risk averse. Exporting creates an implicit hedge against the possibility of regret when the realized spot exchange rate turns out to be high. The regret‐averse firm as such has a greater ex ante incentive to export than the purely risk averse firm. Finally, we use a two‐state example to illustrate that the firm optimally exports more (less) to the foreign country than in the case of pure risk aversion if the low (high) spot exchange rate is more likely to prevail. Regret aversion as such plays a crucial role in determining the firm's optimal allocation between domestic sales and foreign exports.     

Status,Risk-Taking and Intertemporal Substitution in an Endogenous Growth Model

This paper examines intertemporal risk-taking in a stochastically growing economy with externalities in human capital accumulation where agents have preferences for social status. In order to isolate the effects of status concerns on long-run expected growth, the analysis is embedded in a non-expected utility setting, which disentangles the effects from risk aversion and intertemporal substitution. We examine the interaction between status desire and risk, risk aversion and intertemporal substitution. The externalities generated by the status game are able to correct the allocative distortions from the knowledge spillovers.Acknowledgement The author would like to thank an anonymous referee for his valuable comments.     

The Risk and Incentives Trade-off in the Presence of Heterogeneous Managers

Agency theory predicts a negative relationship between risk and incentives, yet recent empirical evidence has not consistently found such a relationship. In fact, some researchers have found a positive relationship. By introducing competition for heterogeneous managers, who differ in their degrees of risk aversion, into a standard agency model, this paper demonstrates that a negative or positive relationship is theoretically possible. Which arises depends on the relative risk aversion parameters of the managers and the absolute and relative riskiness of the environments.Acknowledgement I thank two anonymous referees for helpful comments.     

COMMERCIAL ACTIVITY AS INSURANCE: THE INVESTMENT BEHAVIOUR OF NON‐PROFIT ORGANIZATIONS

ABSTRACT ** : We provide a new explanation for commercial activities by non‐profit organizations whose primary concern is to supply mission output. Starting from the observation that donations to individual non‐profits are often highly volatile, we show how investment in commercial activity can constitute a form of insurance for mission activity. Although investment in commercial activity has an opportunity cost in terms of capacity to produce mission output, if donations turn out to be low the commercial revenue will enable cross‐subsidization of mission output. The equilibrium commercial investment is (weakly) positively related to the degree of risk aversion.     

“Probability of risk aversion” and other applications of derivatives of the certainty equivalent

“Probability of risk” aversion is principally concerned with reactions to scaling up of probabilities of non-zero values of a non-positive random variable by a common factor. Decreasing probability-of-risk aversion is defined and shown to be equivalent to ordinary risk aversion. Implications of this for insurance are pointed out. The sort of scaling involved is the same as that involved in “self-protection,” and it is shown that, for any expenditure on self-protection, say x, a concave utility function will prefer a coinsurance policy, costing x, which leaves probabilities unchanged, but scales down loss amounts by the same proportion as probabilities are scaled under self-protection. Properties of several comparative concepts of decreasing risk aversion are established. Derivatives of the certainty equivalent (CE) are used to elucidate well-known comparative static results in models of expected utility maximization. Finally, the study proves that concavity of the CE implies convexity of the coefficient of absolute risk aversion and examines the role of curvature of the CE in exploring relationships between properties of risk vulnerability, properness, and standardness.

Another Look at the Equity Risk Premium Puzzle

The model of Mehra and Prescott (1985, J. Econometrics, 22, 145–161) implies that reasonable coefficients of risk‐aversion of economic agents cannot explain the equity risk premium generated by financial markets. This discrepancy is hitherto regarded as a major financial puzzle. We propose an alternative model to explain the equity premium. For normally distributed returns and for returns far away from normality (but still light tailed), realistic equity risk premia do not imply puzzlingly high risk aversions. Following our approach, the ‘equity premium puzzle’ does not exist. We also consider fat‐tailed return distributions and show that Pareto tails are incompatible with constant relative risk aversion.     

Preference intensities and risk aversion in school choice: a laboratory experiment

We experimentally investigate in the laboratory prominent mechanisms that are employed in school choice programs to assign students to public schools and study how individual behavior is influenced by preference intensities and risk aversion. Our main results show that (a) the Gale–Shapley mechanism is more robust to changes in cardinal preferences than the Boston mechanism independently of whether individuals can submit a complete or only a restricted ranking of the schools and (b) subjects with a higher degree of risk aversion are more likely to play “safer” strategies under the Gale–Shapley but not under the Boston mechanism. Both results have important implications for enrollment planning and the possible protection risk averse agents seek.     

Will Self‐Managed Superannuation Fund Investors Survive?

The relative risk aversion coefficient that characterises the representative self‐managed superannuation fund (SMSF) investor reveals not only how much that investor dislikes risk but also other information about the investor's economic characteristics, including how his or her allocations to risky assets change as his or her wealth changes. Determination of the relative risk aversion coefficient for the average SMSF investor reveals a value of 5.05. This value is too high to be consistent with logarithmic utility. This is significant because it implies that SMSF investors may be too risk averse to maximise the expected growth rate of wealth share accumulation. We are left to consider a very important question: Will SMSF investors survive?     

Risk aversion and framing effects

We present a new experimental evidence of how framing affects decisions in the context of a lottery choice experiment for measuring risk aversion. We investigate framing effects by replicating the Holt and Laury’s (Am. Econ. Rev. 92:1644–1655, 2002) procedure for measuring risk aversion under various frames. We first examine treatments where participants are confronted with the 10 decisions to be made either simultaneously or sequentially. The second treatment variable is the order of appearance of the ten lottery pairs. Probabilities of winning are ranked either in increasing, decreasing, or in random order. Lastly, payoffs were increased by a factor of ten in additional treatments. The rate of inconsistencies was significantly higher in sequential than in simultaneous treatment, in increasing and random than in decreasing treatment. Both experience and salient incentives induce a dramatic decrease in inconsistent behaviors. On the other hand, risk aversion was significantly higher in sequential than in simultaneous treatment, in decreasing and random than in increasing treatment, in high than in low payoff condition. These findings suggest that subjects use available information which has no value for normative theories, like throwing a glance at the whole connected set of pairwise choices before making each decision in a connected set of lottery pairs.     

RISK AVERSION AND FIELD OF STUDY CHOICE: THE ROLE OF INDIVIDUAL ABILITY

Does the choice of field of study depend on individual risk aversion? The direction of the relationship between individual risk attitudes and type of university degree chosen is potentially ambiguous. On the one hand, risk averse individuals may prefer degree courses which allow high returns in the labour market; on the other hand, if these degrees expose students to a higher probability of dropping out, those who are more risk averse may be induced to choose less challenging fields. Using data from a sample of students enrolled at a middle‐sized Italian public university in 2009, we find that, controlling for a large number of individual characteristics, more risk averse students are more likely to choose any other field (Humanities, Engineering, and Sciences) rather than Social Sciences. We interpret this result bearing in mind that some of these fields, such as Humanities, involve a reduction in the risk of dropping out, while others (such as Engineering and Sciences) involve a lower risk in the labour market. It also emerges that the effect of risk aversion on degree choice is related to student ability. Risk averse students characterized by high abilities tend to prefer Engineering, while the propensity of risk averse students to enrol in Humanities decreases when ability increases, suggesting that the attention paid to labour market risks and drop‐out risk varies according to student skills.     

On the Value of Life in Rich and Poor Countries and Distributional Weights Beyond Utilitarianism

This paper discusses the use ofdistributional weights in CBA based on a generalBergson-Samuelson SWF. In particular it illustratessome consequences of applying a SWF characterized byconstant inequality aversion (which includes classicalutilitarianism as a special case), together with aconstant relative risk aversion utility function, whencalculating the damage costs of global warming. Itextends and clarifies earlier unintuitive results, andemphasizes that utility must be seen as fully cardinalin terms of levels in this context. In the specialcase of utilitarianism, on the other hand, it issufficient to be able to make interpersonalcomparisons of utility changes.     

Greater prudence and greater downside risk aversion

Variation in the degree of downside risk aversion across decision makers has implications for efficient risk sharing. However, except for small differences in risk preferences, there is no index, analogous to the Arrow-Pratt index of risk aversion, that depends only on local properties of the utility function and indicates the degree of aversion to downside risk. A measure that does depend only on local properties of the utility function u, the index of prudence p=−u^?/u^″, is related to downside risk aversion, which is indicated by a positive value for u^?. Although we show that the degree of prudence is not an accurate indicator of the degree of downside risk aversion, we nonetheless demonstrate that a uniform increase in prudence accompanied by a uniform increase (decrease) in risk aversion is sufficient to indicate greater downside risk aversion, provided prudence is greater (less) than three times the degree of risk aversion.     

The relation of risk attitudes and other-regarding preferences: A within-subjects analysis

In this paper we provide experimental evidence on the relation of individual risk attitudes and subjects׳ aversion to favorable inequality. In a within-subjects design we expand Blanco et al.׳s (2011) modified dictator game by the risk-elicitation task of Eckel and Grossman (2002). Our data show strong support for a significant negative correlation between risk tolerance and an aversion to favorable inequality. The results are independent of gender, i.e., women and men show a similar correlation in these traits.