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Probability and Risk: Foundations and Economic Implications of Probability-Dependent Risk Preferences

  • Helga Fehr-Duda

    ()

    ( Institute for Environmental Decisions, ETH Zürich, 8092 Zürich, Switzerland)

  • Thomas Epper

    ()

    ( Institute for Environmental Decisions, ETH Zürich, 8092 Zürich, Switzerland
    Department of Economics, University of Zürich, 8006 Zürich, Switzerland)

A large body of evidence has documented that risk preferences depend nonlinearly on outcome probabilities. We discuss the foundations and economic consequences of probability-dependent risk preferences and offer a practitioner's guide to understanding and modeling probability dependence. We argue that probability dependence provides a unifying framework for explaining many real-world phenomena, such as the equity premium puzzle, the long-shot bias in betting markets, and households' underdiversification and their willingness to buy small-scale insurance at exorbitant prices. Recent findings indicate that probability dependence is not just a feature of laboratory data, but is indeed manifest in financial, insurance, and betting markets. The neglect of probability dependence may prevent researchers from understanding and predicting important phenomena.

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File URL: http://www.annualreviews.org/doi/abs/10.1146/annurev-economics-080511-110950
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Article provided by Annual Reviews in its journal Annual Review of Economics.

Volume (Year): 4 (2012)
Issue (Month): 1 (07)
Pages: 567-593

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Handle: RePEc:anr:reveco:v:4:y:2012:p:567-593
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