Loss Aversion Utility Research Articles

Research on dynamic behavior hedging of corn price risk based on the LA-DCC-GARCH model under COVID-19

The ravages of COVID-19 have had a huge impact on the global economy, and in the grain market, grain prices have fluctuated greatly due to the impact of factors such as rising circulation costs and sudden panicky demand, which has increased the business risks of sellers and deep-processing enterprises. To effectively reduce and avoid the risks brought by COVID-19, this paper takes utility maximization as the goal and helps grain enterprises manage grain price risks by constructing optimal dynamic behavioral hedging strategies. Therefore, this paper first measures the corn price risk during COVID-19, and then, fits the corn spot and futures yield fluctuations based on the DCC-GARCH model, which highlights the model’s advantages for portraying the corn spot and futures price fluctuations during COVID-19. Subsequently, the dynamically optimal hedging ratio is solved from the perspective of behavioral hedging by combining the loss aversion (LA) utility function. Finally, the LA-DCC-GARCH model is compared with the Minimum variance (MV)-DCC-GARCH model in terms of hedging performance, which highlights the conclusion that the behavioral hedging strategy significantly outperforms the traditional hedging strategy.

An uncertainty theory based tri-objective behavioral portfolio selection model with loss aversion and reference level using a modified evolutionary root system growth algorithm

The outbreak of uncertain events, e.g., financial crisis, regional conflict and abrupt contagion, has a significant impact on residents’ income. Hence, the wealth management and portfolio selection become more and more important. In addition, the behavioral finance believes that decision-making process of the investors not only depend on utility maximization, but also on who to compare with. It differs from the traditional finance based on rational cognitive acquiring and decision-making of agents, in this paper, we consider both investment uncertainty and investment utility with reference level for portfolio selection. First, we introduce the uncertainty theory and loss aversion utility with reference level based on behavioral finance. Then we study an uncertain multi-period portfolio selection problem. Moreover, we formulate an uncertain behavioral portfolio selection model with three objective functions for which we propose an equivalent program consisting of a main model and two auxiliary models for tri-objective optimization model. Thereafter, we use a modified evolutionary root system growth algorithm to solve the transformed models. Finally, a numerical simulation allows to show the practicability of proposed models and validity of modified algorithm.

Retailers’ optimal ordering policies for a dual-sourcing procurement

PurposeOptimal ordering decision for a retailer in a dual-sourcing procurement is an important research area. The main purpose of this paper is to explore a loss-averse retailer’s ordering decision in a dual-sourcing problem.Design/methodology/approachFor a loss-averse retailer, the study obtains the optimal ordering decision to maximize expected utility. Based on sensitivity analysis, the properties of the optimal ordering decision are well discussed.FindingsUnder the optimal ordering quantity that maximizes expected loss aversion utility, the relevant expected profit of a retailer turns to be smaller under a bigger loss aversion coefficient. For this point, a retailer needs to balance between expected loss aversion utility maximization and expected profit maximization in deciding the optimal ordering policy in a dual-sourcing problem.Originality/valueThis paper reveals the influence of loss aversion on a retailer’s ordering decision in a dual-sourcing problem. Managerial insights are suggested to devise the optimal ordering policy for retailers in practice.

Loss-averse buyers' optimal procurement decision in a multi-sourcing under e-commerce surroundings

PurposeWith the rapid development of e-commerce, multi-sourcing with supply contracts and spot buying has become more and more popular in reality. The main purpose of the paper is to explore a loss-averse buyer's optimal procurement policy in a multi-sourcing under e-commerce surroundings.Design/methodology/approachThe study introduces the loss aversion utility function to characterize the loss aversion effect and derives a loss-averse buyer's optimal procurement policy in a multi-sourcing with a wholesale price contract and spot market.FindingsA loss-averse buyer could order no items in a wholesale price contract and only needs to replenish commodities from spot market under certain conditions. In addition, the study shows that spot capacity has important influences on a loss-averse buyer's optimal ordering decision in the wholesale price contract.Originality/valueThis is the first paper to study the loss aversion effect on a buyer's procurement decision in a multi-sourcing. The results present important managerial insights for a loss-averse buyer to devise optimal ordering policies in a multi-sourcing under e-commerce surroundings.

Investing for retirement: Terminal wealth constraints or a desired wealth target?

AbstractWe investigate how well different investment strategies can give pre‐retirees more certainty about their income in retirement, whilst allowing them to benefit from taking investment risk. Under an expected utility‐maximizing framework, we find that a loss aversion utility function gives a high degree of certainty about its desired wealth target and is robust to different market models. Imposing terminal wealth constraints does not improve the certainty of achieving the desired target enough to counterbalance the increased chance of obtaining a lower income. The power utility function is not robust to different market models and becomes too risk‐averse with wealth constraints.

Optimal Strategies for Retirees in Australia With Realistic Risk Transfer

We investigate optimal investment and drawdown decisions for Australian retirees, allowing for a range of risk transferring options that could be implemented by superannuation funds. Retirees can allocate their wealth between a life annuity, deferred life annuity, and growth and defensive portfolios in an account-based pension. The preferred asset mix varies significantly with balance and home ownership, and preferences as modelled using both loss aversion and constant relative risk aversion utility. We find that strong loss aversion leads to hedging strategies to secure the target consumption, as reflected in high desire for annuities and subsequent asset allocation and drawdown decisions. Desire for annuities also emerges under risk aversion to both smooth consumption and limit its decline after exhaustion of the account-based pension. We also highlight interactions between the Age Pension and the decisions of Australian retirees. Our results have implications for the design of comprehensive income products for retirement in the Australian market.

Investing for Retirement: How Loss Aversion Risk Preferences Naturally Leads to Greater Retirement Income Certainty

We analyze the ability of different investment strategies to give pre-retirees more certainty about their income in retirement, while allowing them to benefit from taking investment risk. Specifically, we look at the optimal strategies that maximize the expected values of a loss aversion utility function and a constant relative risk aversion (CRRA) utility function. We also include a typical lifestyle strategy. We find that the loss aversion utility function gives a high degree of certainty about its reference point, the latter chosen to give the desired replacement ratio. Adding in constraints on the income purchased at retirement does not improve the certainty of achieving the desired replacement ratio enough to counter-balance the increased chance of obtaining an income far below it. A CRRA utility function fails to get adequate certainty on the retirement income, and becomes too risk-averse when constraints are added. The lifestyle strategy performs well but is overall out-performed by the loss aversion-derived strategy. We include inflation in our model, and allow for inflation-indexed bonds in our investment universe. Our results are analyzed in both a Brownian motion-driven financial market model and using UK historical data.

The Loss-Averse Retailer’s Order Decisions Under Risk Management

This paper characterizes the retailer’s loss aversion by introducing a loss aversion coefficient and proposes a new loss aversion utility function for the retailer. To hedge against the risk arising from the uncertain market demand, we use the Conditional Value-at-Risk (CVaR) measure to quantify the potential risks and obtain the optimal order quantity for the retailer to maximize the CVaR objective of loss aversion utility. It is shown that that the optimal order quantity for a retailer to maximize the expected loss aversion utility is smaller than expected profit maximizing (EPM) order quantity in the classical newsvendor model, which can help to explain decision bias in the newsvendor model. This study shows that the optimal order quantity with the CVaR objective can decrease in retail price under certain conditions, which has never occurred in the newsvendor literature. With the optimal order quantity under the CVaR objective, it is proved that the retailer’s expected loss aversion utility is decreasing in the confidence level. This confirms the fact that high return means high risk, while low risk comes with low return. Based on the results, several management insights are suggested for the loss-averse newsvendor model.

Multi-period and tri-objective uncertain portfolio selection model: A behavioral approach

This paper discusses a multi-period and tri-objective portfolio optimization problem, where asset returns are formalized as uncertain variables. Based on uncertainty theory, a multi-period and tri-objective uncertain portfolio model is proposed, which considers the loss-averse utility, liquidity risk and diversification degree simultaneously. Additionally, a chance constraint is introduced into the model to reflect investors’ safety requirement during the investment period. To solve the portfolio model, a self-adaptive particle swarm optimization (SAPSO) is also proposed. In SAPSO, a self-adaptive stochastic ranking approach is employed to balance the abilities of exploration and exploitation in the searching process. Finally, a numerical experiment is presented. The results show that SAPSO is effective to solve the proposed model and the proposed portfolio model can express investors’ preference by adjusting the objective weights.

Psychic dividends of socially responsible investment portfolios

We provide a measure for the value of the non-financial satisfaction that accrues to individuals from investing in a socially responsible manner. This non-financial benefit is referred to as the ‘psychic dividend’ of socially responsible investing (SRI). Using constant relative risk aversion and loss aversion utility functions, we estimate that investors only need to earn a non-financial benefit of two to six basis points per month for them to be indifferent between investing in SRI and non-SRI portfolios. The estimates are similar in both the USA and the UK. The findings show that more investors are likely to benefit from investing in SRI given the decline in the lower bound on the psychic dividend that we observe over time.

Heterogeneous risk/loss aversion in complete information all-pay auctions

We extend previous theoretical work on n-player complete information all-pay auctions to incorporate heterogeneous risk- and loss-averse utility functions. We provide sufficient and necessary conditions for the existence of equilibria with a given set of active players with any strictly increasing utility functions and characterize the players’ equilibrium mixed strategies. Assuming that players can be ordered by their risk aversion (player a is more risk-averse than player b, if whenever player b prefers a certain payment over a given lottery, so does player a), we find that in equilibrium, the more risk-averse players either bid higher than the less risk-averse players and win with higher ex-ante probability – or they drop out. Furthermore, while each player’s expected bid decreases with the other players’ risk aversion, her expected bid increases with her own risk aversion. Thus, increasing a player’s risk aversion creates two opposing effects on total expected bid. A sufficient condition for the total expected bid to decrease with a player’s risk aversion is that this player is relatively more risk-averse compared to the rest of the players. Our findings have important implications for the literature on gender differences in competitiveness and for gender diversity in firms that use personnel contests for promotions.

Joint Inventory, Pricing, and Advertising Decisions with Surplus and Stockout Loss Aversions

The newsvendor models considering decision-makers’ behavioral factors remain a fruitful research area in operation management field in past decade. In this paper, we further extend the current literatures to look into joint inventory, pricing, and advertising decisions considering loss aversion effects under the newsvendor setting. The purpose is to explore how the loss aversions affect the optimal policy of order quantity, price, and advertising effort level. We present an integrated utility model to measure both economic payoff and loss aversion utility of the newsvendor, where surplus loss aversion and stockout loss aversion are first separately defined and quantified. Then, we analyze the optimal solution conditions of the integrated model under exogenous and endogenous price cases, respectively. Under exogenous price case, we find that the uniquely optimal policy exists and is presented in the closed form. Under endogenous price case, the optimal policy is determined under mild conditions; we also provide the solutions when order quantity factor or advertising effort level is fixed in this case. In addition, the sensitivity analysis shows that the loss aversions affect the optimal decisions of order quantity, price, and advertising effort level in a systematic way.

Competitive insurance pricing with complete information, loss-averse utility and finitely many policies

In a recent paper, Ramsay and Oguledo (2012) show that in a competitive insurance market with complete information about individuals’ accident probabilities and production costs, which are proportional to the amount of insurance purchased and to the premium charged, only individuals whose accident probability is in a medium range are insurable and desire insurance. The purpose of this paper is to complement the analysis of Ramsay and Oguledo by considering production costs which are proportional to the number of policies offered by an insurer. In addition to the result of Ramsay and Oguledo we show that the group of individuals who obtain insurance is partitioned into several subgroups, where each subgroup is offered the same insurance policy. To derive this result we introduce the concept of incentive compatibility which ensures that an individual has no incentive to buy another policy. Assuming that individuals have loss-averse utility, we fully characterize the boundaries of these subgroups as the result of an undercutting process in premiums between the insurers.

The Impact of Optimistic and Pessimistic Preferences on Decision Making

The notion of optimism or pessimism is defined in the psychology literature in terms of forecasting where the term is used more generally than in statistics. Here we use the theory of loss aversion combined with Bayesian forecasting to propose rather precise definitions of optimism and pessimism. Put simply, optimists are those who condition their Bayesian state probabilities on optimistic forecasts whilst pessimists condition their Bayesian state probabilities on pessimistic forecasts. This simple structure leads to closed-form results in asset allocation problems which can be seen as a solution of more general dichotomous problems. Our results with loss aversion utility show that a slightly optimistic (or pessimistic) preference would have a huge impact on the optimal asset allocation.

Optimal insurance contract and coverage levels under loss aversion utility preference

This study develops an optimal insurance contract endogenously and determines the optimal coverage levels with respect to deductible insurance, upper-limit insurance, and proportional coinsurance, and, by assuming that the insured has an S-shaped loss aversion utility, the insured would retain the enormous losses entirely. The representative optimal insurance form is the truncated deductible insurance, where the insured retains all losses once losses exceed a critical level and adopts a particular deductible otherwise. Additionally, the effects of the optimal coverage levels are also examined with respect to benchmark wealth and loss aversion coefficient. Moreover, the efficiencies among various insurances are compared via numerical analysis by assuming that the loss obeys a uniform or log-normal distribution. In addition to optimal insurance, deductible insurance is the most efficient if the benchmark wealth is small and upper-limit insurance if large. In the case of a uniform distribution that has an upper bound, deductible insurance and optimal insurance coincide if benchmark wealth is small. Conversely, deductible insurance is never optimal for an unbounded loss such as a log-normal distribution.

Performance-Based Fees and Asset Allocation Under Loss-Aversion

This paper takes into account the most prevalent practices in terms of fees in order to study the dynamic asset allocation of fund managers exhibiting a loss aversion utility function. Managers are compensated with performance-based (asymmetric and symmetric) fees comprising an underperformance penalty component. The benchmark portfolio relative to which performance of funds is measured may be riskless or risky. Whatever the benchmark, a penalty component may lead managers to take more risk in unfavorable states of the world and less risk in favorable states. In the case of a risky benchmark, a manager also has a position in the benchmark, which is less risky when (s)he faces a penalty.

One-period asset allocation oddity with loss aversion utility

This study considers a one-period asset allocation problem where the economy contains one riskless asset and only one risky asset. We show that the asset allocation is very odd and violates the investment practice for a typical loss aversion utility; that is, the possible investment proportions in risky asset include only zero, positive infinity and negative infinity. This result implies that the conventional increasing and concave utility is more suitable in explaining the practical one-period asset allocation behavior than the typical loss aversion utility.

Downside risk asset pricing revisited: a new non-linear threshold model

We derive an asset pricing equilibrium formula in which the risk premium on a risky asset is given by a weighted sum of the regular beta capital asset pricing model and a market portfolio downside risk beta. The equilibrium model is obtained from a new utility function that builds on the class of downside risk functions introduced in Bawa (1975, 1978) and that can be interpreted as an alternative to the disappointment utility functions of Dekel (1986) and Gul (1991), and the loss aversion utility functions as in Tversky and Kahneman (1991, 1992). This equilibrium model is econometrically represented by a non-linear threshold model that depends on a target return indicating market downturns. In the case where the target return is unknown we introduce an estimator of this threshold and a hypothesis test to assess statistically the significance of the downside risk parameter in the risk premium of the risky asset. An empirical exercise to industry, size and book-to-market portfolios uncovers a strong relationship between the risk premium and market portfolio downside risk

Asymmetric Preferences in Investment Decisions in the Brazilian Financial Market

The main objective of this article is to test the hypothesis that utility preferences that incorporate asymmetric reactions between gains and losses generate better results than the classic Von Neumann-Morgenstern utility functions in the Brazilian market. The asymmetric behavior can be computed through the introduction of a disappointment (or loss) aversion coefficient in the classical expected utility function, which increases the impact of losses against gains. The results generated by both traditional and loss aversion utility functions are compared with real data from the Brazilian market regarding stock market participation in the investment portfolio of pension funds and individual investors.

Aversão a Perdas: Comparação de Decisões de Investimento entre Investidores Individuais e Fundos de Pensão no Brasil

O objetivo deste artigo é analisar se o uso de uma função preferência que incorpora assimetria na reação do investidor frente a ganhos e perdas (aversão a perdas) permite gerar resultados mais coerentes com o comportamento real de investidores brasileiros, na seleção dos seus portfólios de investimento, do que uma função que não incorpora este comportamento (função utilidade tradicional). Os resultados quanto à participação do investimento em ações na composição do portfólio ótimo gerados pelos dois tipos de função são comparados com dados reais agregados de investimentos de dois tipos de investidores brasileiros (fundos de pensão e investidores individuais) visando verificar a capacidade de cada função em replicar o comportamento destes investidores. As simulações indicam que a função utilidade tradicional deve ser rejeitada como modelo representativo do comportamento dos investidores individuais, sendo este comportamento melhor representado por uma função que incorpora aversão a perdas.