Greater prudence and greater downside risk aversion

Abstract

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.