The Case Against Power Utility and a Suggested Alternative: Resurrecting Exponential Utility
AbstractUtility modeled as a power function is commonly used in the literature despite the fact that it is unbounded and generates asset pricing puzzles. The unboundedness property leads to St. Petersburg paradox issues and indifference to compound gambles, but these problems have largely been ignored. The asset pricing puzzles have been solved by introducing habit formation to the usual power utility. Given these issues, we believe it is time re-examine exponential utility. Exponential utility was abandoned largely because it implies increasing relative risk aversion in a cross-section of individuals and nonstationarity of the aggregate consumption to wealth ratio, contradicting macroeconomic data. We propose an alternative preference specification with exponential utility and relative habit formation. We show that this utility function is bounded, consistent with asset pricing facts, generates near-constant relative risk aversion in a cross-section of individuals and a stationary ratio of aggregate consumption to wealth.
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Bibliographic InfoPaper provided by University Library of Munich, Germany in its series MPRA Paper with number 5897.
Date of creation: Jul 2007
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unbounded utility; asset pricing puzzles; habit formation;
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- G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
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