Downside Risk-Aware Equilibria for Strategic Decision-Making

Game theory has traditionally had a relatively limited view of risk based on how a player's expected reward is impacted by the uncertainty of the actions of other players. Recently, a new game-theoretic approach provides a more holistic view of risk also considering the reward-variance. However, these variance-based approaches measure variance of the reward on both the upside and downside. In many domains, such as finance, downside risk only is of key importance, as this represents the potential losses associated with a decision. In contrast, large upside "risk" (e.g. profits) are not an issue. To address this restrictive view of risk, we propose a novel solution concept, downside risk aware equilibria (DRAE) based on lower partial moments. DRAE restricts downside risk, while placing no restrictions on upside risk, and additionally, models higher-order risk preferences. We demonstrate the applicability of DRAE on several games, successfully finding equilibria which balance downside risk with expected reward, and prove the existence and optimality of this equilibria.