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A Potential Contradiction Between Economic Theory and Applied Finance

Author

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  • Shlomo Yitzhaki

    (Department of Economics, Hebrew University, Jerusalem, 91905, ISRAEL; Hadassah Academic College, Jerusalem, 91010, ISRAEL)

Abstract

One of the basic premises that underlies economic theory in Finance is the assumption of declining marginal utility of income. This assumption imposes risk-aversion on the investors and is necessary requirement to an equilibrium capital markets. A popular method of analyzing empirical evidence among financial analysts is the Ordinary Least Squares Regression. This paper argues that in certain cases involving violation of the linearity assumption by the data, there may be a contradiction between the two approaches. In order to resolve the possibility of a contradiction one has to impose economic theory on the regression. The paper proposes the use of the Gini regression to bridge the gap between economic theory and regression.

Suggested Citation

  • Shlomo Yitzhaki, 2016. "A Potential Contradiction Between Economic Theory and Applied Finance," Review of Economics & Finance, Better Advances Press, Canada, vol. 6, pages 13-27, May.
    • Handle: RePEc:bap:journl:160202
    Note: The author is grateful to an anonymous referee and Haim Shalit for helpful comments.
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    References listed on IDEAS

    as
    1. Haim Shalit & Shlomo Yitzhaki, 2010. "How does beta explain stochastic dominance efficiency?," Review of Quantitative Finance and Accounting, Springer, vol. 35(4), pages 431-444, November.
    2. Leshno, Moshe & Levy, Haim & Spector, Yishay, 1997. "A Comment on Rothschild and Stiglitz's "Increasing Risk: I. A Definition"," Journal of Economic Theory, Elsevier, vol. 77(1), pages 223-228, November.
    3. G. Hanoch & H. Levy, 1969. "The Efficiency Analysis of Choices Involving Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 36(3), pages 335-346.
    4. Haim Shalit & Shlomo Yitzhaki, 2009. "Capital market equilibrium with heterogeneous investors," Quantitative Finance, Taylor & Francis Journals, vol. 9(6), pages 757-766.
    5. Yitzhaki, Shlomo, 1983. "On an Extension of the Gini Inequality Index," International Economic Review, Department of Economics, University of Pennsylvania and Osaka University Institute of Social and Economic Research Association, vol. 24(3), pages 617-628, October.
    6. Rothschild, Michael & Stiglitz, Joseph E., 1970. "Increasing risk: I. A definition," Journal of Economic Theory, Elsevier, vol. 2(3), pages 225-243, September.
    7. Rothschild, Michael & Stiglitz, Joseph E., 1971. "Increasing risk II: Its economic consequences," Journal of Economic Theory, Elsevier, vol. 3(1), pages 66-84, March.
    8. Kanniainen, Juho, 2007. "Rothschild-Stiglitz's definition of increasing risk and the relationship between volatility and risk premium," Review of Financial Economics, Elsevier, vol. 16(4), pages 363-374.
    9. Yitzhaki, Shlomo, 1996. "On Using Linear Regressions in Welfare Economics," Journal of Business & Economic Statistics, American Statistical Association, vol. 14(4), pages 478-486, October.
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    Citations

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    Cited by:

    1. Schröder, Carsten & Yitzhaki, Shlomo, 2017. "Revisiting the evidence for cardinal treatment of ordinal variables," European Economic Review, Elsevier, vol. 92(C), pages 337-358.

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    More about this item

    Keywords

    Stochastic dominance; OLS regression; Gini regression;
    All these keywords.

    JEL classification:

    • C00 - Mathematical and Quantitative Methods - - General - - - General
    • C50 - Mathematical and Quantitative Methods - - Econometric Modeling - - - General
    • C53 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Forecasting and Prediction Models; Simulation Methods
    • C58 - Mathematical and Quantitative Methods - - Econometric Modeling - - - Financial Econometrics

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