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On the quality of Taylor approximations to expected utility

  • Georgios Skoulakis
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    This article presents evidence on the quality of Taylor series approximations to expected utility. To provide a transparent assessment in a broader setting, we assume that log portfolio returns follow a Gram--Charlier distribution that incorporates skewness and excess kurtosis and consider an investor with Constant Relative Risk Aversion (CRRA) preferences. In this framework, we obtain closed-form approximations to expected utility based on Taylor expansions with respect to gross and log portfolio return. We illustrate the quality of the two approximations across a wide range of scenarios in terms of distribution parameters and levels of risk aversion. The Taylor expansion with respect to log portfolio return is shown to produce reliable approximations.

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    Article provided by Taylor & Francis Journals in its journal Applied Financial Economics.

    Volume (Year): 22 (2012)
    Issue (Month): 11 (June)
    Pages: 863-876

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    Handle: RePEc:taf:apfiec:v:22:y:2012:i:11:p:863-876
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