Coefficient Of Risk Aversion Research Articles

Portfolio Selection with Hierarchical Isomorphic Risk Aversion

Researchers usually specify risk aversion coefficients from 1 (lowest) to M (highest) for a portfolio to indicate active or passive approaches. How effective is this practice? Recent studies suggest that the global minimum variance portfolio (GMVP) is statistically equivalent to portfolios with extensive risk aversion coefficients (the GMVP-equivalent). Expressing the risk aversion coefficient as a Taylor series of the target return and efficient set constants, we generalize the previous result to the non-GMVP-equivalents and segment mean-variance portfolios according to a hierarchy of risk aversion coefficients. In this paper, we show that hierarchical risk aversion coefficients are superior to isometric attributes.

An endogenous evolution mechanism model of asset prices based on time-varying risk aversion coefficient

In the traditional heterogeneous agent model, investors are assumed to be risk averse, and the wealth expected utility function maximization principle is used to form the optimal asset quantity demand. In such models, the risk aversion coefficient of investors is often assumed to be constant. This paper considers that the risk aversion coefficient of investors is time-varying and changes with the change of wealth, and establishes an endogenous evolutionary mechanism model formed by fundamental analysts, technical analysts, and market makers. Compared with the fixed risk aversion coefficient model, this paper analyzes the investor’s behavior, the interaction between investor behaviors, and the influence of different types of investors on the stability of the market. At the same time, we test asset price and asset behavior and conclude that investor behavior affects the stability of the system model. The numerical simulation of the corresponding stochastic model shows that the model can simulate the basic characteristics of financial time series, such as the partial peak and thick tail of asset return series, and the long memory of fluctuations.

Time‐varying risk preference and equity risk premium forecasting: The role of the disposition effect

AbstractThis study examines whether the disposition effect can explain time‐varying risk preference and predict the equity risk premium. To do so, we propose an augmented general autoregressive conditional heteroskedasticity (GARCH)‐in‐Mean model unraveling the complex relationship between unrealized gains/losses, realized returns, and the equity risk premium. In our model, the risk aversion coefficient varies with the market state of unrealized gains/losses. Using data from the US stock markets, we show strong evidence that the disposition effect drives time‐varying risk preference: The risk aversion coefficient is significantly positive during periods of unrealized gains, but insignificant during periods of unrealized losses. These findings reconcile the conflicting results of the risk‐return trade‐off in existing literature. Moreover, our model shows significant predictability of the equity risk premium, both in‐sample and out‐of‐sample. Incorporating our model's predictions can yield substantial utility gains for a mean‐variance investor. Our results indicate that the disposition effect leads to time‐varying risk preference and thus induces equity risk premium predictability.

Bidding Strategy for Wind and Thermal Power Joint Participation in the Electricity Spot Market Considering Uncertainty

As the proportion of new energy sources, such as wind power, in the electricity system rapidly increases, their participation in spot market competition has become an inevitable trend. However, the uncertainty of clearing price and wind power output will lead to bidding deviation and bring revenue risks. In response to this, a bidding strategy is proposed for wind farms to participate in the spot market jointly with carbon capture power plants (CCPP) that have flexible regulation capabilities. First, a two-stage decision model is constructed in the day-ahead market and real-time balancing market. Under the joint bidding mode, CCPP can help alleviate wind power output deviations, thereby reducing real-time imbalanced power settlement. On this basis, a tiered carbon trading mechanism is introduced to optimize day-ahead bidding, aiming at maximizing revenue in both the electricity spot market and carbon trading market. Secondly, conditional value at risk (CVaR) is introduced to quantitatively assess the risks posed by uncertainties in the two-stage decision model, and the risk aversion coefficient is used to represent the decision-maker’s risk preference, providing corresponding strategies. The model is transformed into a mixed-integer linear programming model using piecewise linearization and McCormick enveloping. Finally, the effectiveness of the proposed model and methods is verified through numerical examples.

The Bitcoin Premium: A Persistent Puzzle

Abstract On average, stocks have a much higher rate of return than bonds; this has led to research on the equity premium puzzle. Similarly, Bitcoin outperforms stocks; I call this the Bitcoin premium puzzle. I show that standard macroeconomic models predict a low or negative Bitcoin premium. Though Bitcoin is extremely volatile, the model is rejected even when the coefficient of relative risk aversion is above 10. The Bitcoin premium declined after a structural break in late 2013. However, the puzzle is persistent; there has been no downward trend in the premium since.

Effect of risk aversion on the performance of supply chain and carbon reducing initiatives under asymmetric information

AbstractThis paper considers a supply chain in which the risk‐averse manufacturer invests in carbon emission reduction (CER) technology and the risk‐averse retailer makes green sales efforts to reduce carbon footprint. The results show that when the information is symmetrical, the two‐part tariff contract can eliminate the double‐marginalization effect. Moreover, when the information is asymmetric, the manufacturer encourages retailer to report true market size and improve green sales effort by providing an incentive contract. This menu of contract ensures the manufacturer obtains more utilities with low carbon emissions. In addition, through the analysis of risk aversion coefficients, we find that under centralized decision, with the improvement of risk aversion awareness, both supply chain players will reduce the green efforts. However, under asymmetric information, compared with the manufacturer, the retailer's higher risk aversion will have an opposite effect on the equilibrium decision‐making, utilities, and carbon footprint of the supply chain.

Risk preferences over health: Empirical estimates and implications for medical decision-making

Mainstream health economic theory implies that an expected gain in health-related quality of life (HRQoL) produces the same value for consumers, regardless of baseline health. Several strands of recent research call this implication into question. Generalized Risk-Adjusted Cost-Effectiveness (GRACE) demonstrates theoretically that baseline health status influences value, so long as consumers are not risk-neutral over health. Prior empirical literature casts doubt on risk-neutral expected utility-maximization in the health domain. We estimate utility over HRQoL in a nationally representative U.S. population and use our estimates to measure risk preferences over health. We find that individuals are risk-seeking at low levels of health, become risk-averse at health equal to 0.485 (measured on a 0–1 scale), and are most risk-averse at perfect health (coefficient of relative risk aversion = 4.51). We develop the resulting implications for medical decision making, cost-effectiveness analyses, and the proper theory of health-related decision making under uncertainty.

Investigating the Impact of Consumption Distribution on CRRA Estimation: Quantile-CCAPM-Based Approach

Abstract Using quantile maximization decision theory, this paper considers a quantile-based Euler equation that states that the asset price is a function of the quantiles of the payoff, consumption growth, the stochastic discount factor, risk aversion, and the distribution of the consumption growth rate. We use a more general distribution assumption (log-elliptical distributions) than the log-normality of the consumption growth rate assumed in the literature. The simulation results show that: (1) the higher the downside risk aversion, the lower the constant relative risk aversion; (2) the heavier the tails of the Student-t distribution, the higher the risk aversion for each level of downside risk aversion; and (3) the curve of the relationship between risk aversion and downside risk aversion shifts upward when the normality assumption is dropped, and the magnitude of this shift is high even for high degrees of freedom of the Student-t distribution. Our results suggest that using normally distributed errors to model stock returns and consumption growth rates could lead to an underestimation of the risk aversion coefficient.

Salience effect and yield curve

This paper studies the influence of salience on nominal and real yield curves by introducing the salience effect in the Piazzesi and Schneider model (hereafter PS). We construct the salience values based on the expected consumption growth using U.S. data. We find that salience values are negatively correlated with the expected consumption growth rates. Based on U.S. data from 1960q1 to 2020q4, we find that the salience model can generate upward nominal and real yield curves within reasonable risk aversion coefficients (less than 10), as well as well-fitted average yields with actual data. The salience model compensates for the PS or recursive preference model’s inability to generate an upward nominal or real yield curve within reasonable risk aversion. Furthermore, we provide empirical support for model implications.

Trade credit contracting in a risk-averse supply chain under adverse selection and moral hazard

Trade credit, as an effective tool for integrating and coordinating material, information, and financial flows in supply chain management, is becoming increasingly widespread. We explore how a manufacturer can design optimal trade credit contracts when a risk-averse retailer hides its sales cost information (adverse selection) and selling effort level (moral hazard). We develop incentive models for a risk-averse supply chain when adverse selection and moral hazard coexist, which are then compared with the results under single information asymmetry (moral hazard). Moreover, we analyze the effects of private information and risk-aversion coefficient on contract parameters, selling effort level and the profit or utility of the supply chain. The study shows that when the degree of retailer’s risk aversion is within a certain range, reasonable trade credit contracts designed by the manufacturer can effectively induce the retailer to report its real sales cost and encourage it to exert appropriate effort. Furthermore, we find that the optimal trade credit period, optimal transfer payment, and retailer’s optimal sales effort level under dual information asymmetry are less than under single information asymmetry. Numerical analysis are conducted to demonstrate the effects of the parameters on decisions and profits.

Welfare effects of unemployment benefits when informality is high

We investigate the welfare effects of unemployment benefits (UBs) in the context of high informality, analyzing matched administrative and survey data with detailed information on consumption, transfers and informal and formal employment of UB recipients. Difference-in-differences analysis reveals a comparatively large consumption drop after the loss of a formal job, resulting from shifts towards lower-quality informal employment and an associated earnings penalty. Exploiting a UB kink, we then show that higher UBs delay program exit through a substitution of formal with informal employment. Even when conservatively estimated, however, welfare effects are positive for coefficients of risk aversion exceeding two.

Risk Preference Types, Limited Consideration, and Welfare

We provide sufficient conditions for semi-nonparametric point identification of a mixture model of decision making under risk, when agents make choices in multiple lines of insurance coverage (contexts) by purchasing a bundle. As a first departure from the related literature, the model allows for two preference types. In the first one, agents behave according to standard expected utility theory with CARA Bernoulli utility function, with an agent-specific coefficient of absolute risk aversion whose distribution is left completely unspecified. In the other, agents behave according to the dual theory of choice under risk combined with a one-parameter family distortion function, where the parameter is agent-specific and is drawn from a distribution that is left completely unspecified. Within each preference type, the model allows for unobserved heterogeneity in consideration sets, where the latter form at the bundle level—a second departure from the related literature. Our point identification result rests on observing sufficient variation in covariates across contexts, without requiring any independent variation across alternatives within a single context. We estimate the model on data on households’ deductible choices in two lines of property insurance, and use the results to assess the welfare implications of a hypothetical market intervention where the two lines of insurance are combined into a single one. We study the role of limited consideration in mediating the welfare effects of such intervention.

Evolutionary game analysis for multi-level collaborative governance under public crisis in China: From a value perception perspective.

In a risk society, the survival and development of humans are facing threats of complex and severe public crisis events. Public participation in collaborative governance (CG) of public crisis events is increasingly recognized as an important direction for the reform of the current and future emergency management system. Previous studies of CG have mainly focused on the macro level and ignored to address micro-level discussions of the behavioral strategy evolution of stakeholders. From a fresh value perception perspective, this study constructs an evolutionary game model to clarify the evolution mechanism of multi-level emergency CG. First, the value perception model is built based on Prospect Theory and Mental Accounting to optimize the traditional game matrix. Second, the evolutionary stability is analyzed to solve the system evolution law. Finally, numerical simulation is conducted in the case of Heilongjiang province, a main region of food and energy supply in China. Results showed that (1) the CG game system has a complex evolutionary path; (2) the behavior of game players is affected by perceived incomes and perceived costs; (3) compared with the reference value and the risk aversion coefficient of income accounts, game players are more sensitive to that of cost accounts; (4) enhancing the perceived value of public psychological satisfaction and government reputation is helpful for the long-term construction of CG. Overall, this study aims to highlight the potential utility of value perception in promoting effective implementations of CG and to provide new insights for the development of CG in China and other countries.

Opportunity knocks but just once: Impact of infrastructure investment decision on climate adaptation to flood events

Extreme natural disasters caused by climate change and socio-economic development, such as floods, are likely to occur more frequently and impose an increasing threat on the safety of people‘s lives and property around the world. The infrastructure investment of adaptation projects can effectively prevent and mitigate these climate impacted disaster risks, as well as reducing the catastrophic losses. In this paper, we propose an economic evaluation framework to incorporate risk preferences and investment timing for making climate adaptation. We use an extended loss distribution approach (LDA) to estimate the expected economic loss (EEL) of flood events with different levels, in which the Bayesian inference is integrated to estimate the parameters of loss severity distributions. The modeling framework is applied to a case study of flood risk management in Nanjing City, China. We find that the appropriate delay of investment timing can significantly increase the value of the adaptation project. The optimal investment timing is earlier, and the project value under optimal investment timing is higher, when the risk aversion coefficient of insurance company or the asset growth rate becomes higher. A lower discount rate or a lower investment cost will accelerate the optimal investment timing. Interestingly, we also find that the greater the difference between the discount rate and the asset growth rate, the higher the value of the adaptation project under the optimal investment timing. These findings are expected to provide useful information on flood disasters prevention for the investment decision of adaptation infrastructure which can be economically effective to integrate the impacts of climate change and socio-economic development.

Pricing and contract preference in maritime supply chains with downstream competition impact of risk-aversion and contract unobservability

The maritime market has been facing increasingly fierce competition. Most of the existing literature in maritime supply chain assumes that the details of the contracts between ports and carriers are common knowledge among all competing carriers. In reality, it is usually difficult for carriers to be fully aware of each other's contracts with ports. In view of this, we consider two representative contracts, namely wholesale price contact and two-tariff contract, construct a maritime supply chain with one port and two carriers, and analyze how risk-aversion behavior and contract unobservability impact the pricing and contract preference. We use passive beliefs as an equilibrium refinement criterion to solve the model. Our findings indicate that the carrier prefers the wholesale price contract, regardless of whether the contract is observable or not. The port tends to select the two-part tariff contract when the contract is observable. When faced with an unobservable contract, contract preference of the port depends on the competition intensity and degree of risk-aversion. Additionally, under the wholesale price contract, the port can benefit from the decrease of its risk-aversion coefficient and the increase of the carrier's risk-aversion coefficient, while the carrier is exactly the opposite. Meanwhile, the utility of the port can be increased or reduced by the increase in carrier's risk-aversion coefficient under the two-part tariff contract.

Forecasting commodity prices returns: The role of partial least squares approach

This paper put forwards a novel aligned technical index, which eliminates a common noise component in technical indicators by employing the partial least squares (PLS) method, to investigate the predictability of commodity price returns.Our results show that the novel aligned technical index delivers powerful predictive ability statistically and economically under both in-sample and out-of-sample conditions. Specifically, the novel aligned technical index generates in-sample R2of 10.74%, much larger than the economically significant R2 benchmark of 0.5%. Meanwhile, the out-of-sample ROS2 of our new aligned technical index reaches 11.46%, while the highest ROS2 generated by the eight macroeconomic variables is only 5.26%. Furthermore, we also execute a range of robustness tests with respect to the business cycle, subsample periods, different risk aversion coefficients and the transaction cost. The new technical index is consistent and stable to various robustness checks.

Measuring the Effects of Risk Aversion Change on Households’ Performance Using Endogenous Discount Factor Model

Given the importance of household time preference and risk aversion as macroeconomic variables that play a role in capital accumulation, growth and economic development and are one of the main roots of interest rates, they play an important role in the equilibrium of the economy and society. On the other hand, economic development, improvement of living standards and prosperity of society have always been among the most important issues faced by the planners of a country, and one of the conditions is to achieve higher economic growth in society. The existence of time preference and discount factor, which show the degree of patience of society in terms of consumption and the value of current consumption over future consumption. This article attempts to investigate the role of risk aversion in the presence of an endogenous discount factor on macroeconomic variables and household performance in the context of a DSGE model. The study of household data of the Iranian economy for the period 1998 to 2020 shows that given the fact that people in the community are sensitive to the decision to increase their expected desirability at a certain level of risk and care about it, increasing the risk aversion coefficient in the desirability function of the household leads to fluctuations and changes in the optimal path of the economic variables of the household and finally the change in allocations is adjusted to attribute the maximum expected return to its portfolio. Indeed, increasing risk aversion leads households to allocate their resources optimally between periods (present and future) by paying more attention to their time.

A formula for the elasticity of substitution of a large class of smooth utility functions

We derive a general formula for the elasticity of substitution of a large class of smooth utility functions. This formula depends critically on two terms: the marginal rate of substitution and the elasticity of marginal utility, which may be interpreted according to the context either as the coefficient of relative risk aversion or as the intertemporal elasticity of substitution. This formula works for homothetic and non-homothetic utility functions. Besides, it holds for two important class utility functions often used in both empirical and theoretical works: the quasi-linear utility and the Stone-Geary utility functions.

Competitive search with two-sided risk aversion

Search theory is widely used in economics to study markets where trading frictions are prevalent. However, all existing theoretical models assume that either buyers or sellers (or both) are risk neutral, and the case where both parties are risk averse remains unexplored. This paper is a first step to fill this gap. I analyze a static competitive search model where risk-averse agents with different wealth seek to exchange an indivisible good. The housing market is an important application since a home typically represents a large part of a person’s wealth. I prove that a competitive search equilibrium is constrained efficient, and derive a generalized Hosios condition that relates the gains of the two parties in each transaction. Under risk aversion, wealthier buyers are more concerned with increasing their trading probability than with getting the best price. The opposite is true for sellers when the coefficient of absolute risk aversion is non-increasing. This results in positive sorting in equilibrium, that is, wealthier (poorer) buyers and sellers trading with each other at higher (lower) prices. This sorting mechanism offers a novel explanation for why the separation between rich and poor neighborhoods can be persistent.

A One-Factor Model of Corporate Bond Premia

A one-factor model based on long-run consumption growth explains the risk premiums on corporate bond portfolios sorted on credit rating, credit spreads, downside risk, idiosyncratic volatility, long-term reversals, maturity, and sensitivity to the financial intermediary capital factor. The estimated risk-aversion coefficient is lower when we use the consumption growth of wealthy households over a longer horizon as a risk factor, and a model with a 20-quarter horizon yields a risk-aversion coefficient of 15, a value similar to the one estimated from equity portfolios. This paper was accepted by Bruno Biais, finance. Funding: Y. Nozawa acknowledges funding from the Center for Investing at the Hong Kong University and Science and Technology. Supplemental Material: The data files and online appendix are available at https://doi.org/10.1287/mnsc.2023.4784 .