Reaching for Returns in Retail Structured Investment

The growing market for retail structured investment products and empirical evidence for excessive pricing of such products raise the hypothesis that private investors show increased risk appetite in structured investment contexts. A two-stage framed field experiment building on cumulative prospect theory is designed to test this hypothesis. Subjects’ expectations regarding the future performance of an underlying index are elicited first. A bisection algorithm is then applied to derive the certainty equivalents of 20 simple individually tailored deposits. The results support the increased risk appetite hypothesis, revealing that subjects reach for substantial gains and underweight tail loss events when evaluating the deposits. Similar results emerge in a follow-up experiment where the uncertain deposits are replaced by risky versions. While previous studies propose that misperception of complex terms and optimism contribute to the mispricing of structured instruments, the current experiments show that nonstandard risk appetite manifests in the valuation of simple well-defined products, controlling for expectations. This paper was accepted by Manel Baucells, decision analysis.

Efficiency, equity, and social rationality under uncertainty

In a simple model where agents’ monetary payoffs are uncertain, this paper examines the aggregation of subjective expected utility functions which are interpersonally noncomparable. A maximin social welfare criterion is derived from axioms of efficiency, ex post equity, and social rationality, combined with the independence of beliefs and risk preferences in riskless situations (Chambers and Echenique in Games Econ Behav 76:582–595, 2012). The criterion compares allocations by the values of the prospects composed of the statewise minimum payoffs evaluated by the certainty equivalents. Because of this construction, the criterion is egalitarian and risk averse.

Eliciting Risk Preferences and Elasticity of Substitution

Risk aversion and elasticity of intertemporal substitution (EIS) are separated via the celebrated recursive utility building on certainty equivalents of indirect utility. Based on an alternative separation method, we formulate a questionnaire for simultaneous and consistent estimation of risk aversion, subjective discount rate, and EIS. From a representative group of 1,153 respondents, we estimate parameters for these preferences and their variability within the population. Risk aversion and the subjective discount rate are found to be in the orders of 2 and 0, respectively, not diverging far away from results from other studies. Our estimate of EIS in the order of 10 is larger than often reported. Background variables like age and income have little predictive power for the three estimates. Only gender has a significant influence on risk aversion in the usually perceived direction that females are more risk-averse than males. Using individual estimates of preference parameters, we find covariance between preferences toward risk and EIS. We present the background reasoning on objectives, the questionnaire, a statistical analysis of the results, and economic interpretations of these, including relations to the literature.

Sources of Uncertainty and Subjective Prices

We develop a general framework to study source-dependent preferences in economic contexts. We behaviorally identify two key features. First, we drop the assumption of uniform uncertainty attitudes and allow for source-dependent attitudes. Second, we introduce subjective prices to compare outcomes across different sources. Our model evaluates profiles source-wise, by computing the source-dependent certainty equivalents; the latter are converted into the unit of account of a common source and then aggregated into a unique evaluation. By viewing time and location as instances of sources, we show that subjective discount factors and subjective exchange rates are emblematic examples of subjective prices. Finally, we use the model to explore the implications on optimal portfolio allocations and home bias.

Probability range and probability distortion in a gambling task

In decision making under risk, adults tend to overestimate small and underestimate large probabilities (Tversky & Kahneman, 1992). This inverse S-shaped distortion pattern is similar to that observed in a wide variety of proportion judgment tasks (see Hollands & Dyre, 2000, for review). In proportion judgment tasks, distortion patterns tend not to be fixed but rather to depend on the reference points to which the targets are compared. Here, we tested the novel hypothesis that probability distortion in decision making under risk might also be influenced by reference points—in this case, references implied by the probability range. Adult participants were assigned to either a full-range (probabilities from 0-100%), upper-range (50-100%), or lower-range (0-50%) condition, where they indicated certainty equivalents for 176 hypothetical monetary gambles (e.g., “a 50% chance of $100, otherwise $0”). Using a modified cumulative prospect theory model, we found only minimal differences in probability distortion as a function of condition, suggesting no differences in use of reference points by condition, and broadly demonstrating the robustness of distortion pattern across contexts. However, we also observed deviations from the curve across all conditions that warrant further research.

Law invariant risk measures and information divergences

Aone-to-one correspondence is drawnbetween lawinvariant risk measures and divergences,which we define as functionals of pairs of probability measures on arbitrary standard Borel spaces satisfying a few natural properties. Divergences include many classical information divergence measures, such as relative entropy and convex f -divergences. Several properties of divergence and their duality with law invariant risk measures are characterized, such as joint semicontinuity and convexity, and we notably relate their chain rules or additivity properties with certain notions of time consistency for dynamic law risk measures known as acceptance and rejection consistency. The examples of shortfall risk measures and optimized certainty equivalents are discussed in detail.

Strategies to manage hail risk in apple production

Purpose Hail risk management is essential for successful farm management in German fruit production, particularly because hail events and associated losses have increased in recent years. The purpose of this paper is to conduct a detailed risk analysis comparing different strategies to manage hail risk, taking into account farmers’ risk aversion and farm-specific conditions. Design/methodology/approach Within an expected utility framework, two different strategies for managing hail risk are compared: one belonging to the group of financial instruments (hail insurance) and the other to the group of technical instruments (anti-hail net). A unique data set comprising a ten-year time series of orchard-specific hail damage and hail insurance data is used. Findings For orchards with low local hail risk and low yield potential, not using hail risk mitigation is most efficient. For orchards with high local hail risk and high yield potential, anti-hail nets provide the highest certainty equivalents. For orchards with high local risk, but low yield potential, hail insurance is most efficient. For orchards, with low local risk, but high yield potential, the certainty equivalents are higher for anti-hail net, when the farmer is risk neutral or slightly risk-averse. With increasing risk aversion, hail insurance is most efficient, which can be explained by the greater degree of the instrument’s flexibility. Originality/value The novelty of the study lies in the direct comparison of the risk effects of anti-hail nets and hail insurance in fruit production.