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The Behavioural Components of Risk Aversion

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  • Davies, G.B.
  • Satchell, S.E.

Abstract

The risk premium is affected by loss aversion and probability distortions as well as utility curvature. We introduce two variants - the total risk premium relative to objective expected value, and the subjective risk premium relative to perceived expected value. Approximate solutions for each provide analogies to the Pratt-Arrow coefficient of risk aversion (showing how risk attitude depends on each behavioural component), and sufficient conditions for risk aversion. Earlier results of Levy and Levy (2002) which examined decision weights in isolation are revised and extended to show how the curvature and loss aversion conditions are affected by probability distortions.

Suggested Citation

  • Davies, G.B. & Satchell, S.E., 2004. "The Behavioural Components of Risk Aversion," Cambridge Working Papers in Economics 0458, Faculty of Economics, University of Cambridge.
    • Handle: RePEc:cam:camdae:0458
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    References listed on IDEAS

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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Kobberling, Veronika & Wakker, Peter P., 2005. "An index of loss aversion," Journal of Economic Theory, Elsevier, vol. 122(1), pages 119-131, May.
    3. Levy, Haim & Levy, Moshe, 2002. "Arrow-Pratt Risk Aversion, Risk Premium and Decision Weights," Journal of Risk and Uncertainty, Springer, vol. 25(3), pages 265-290, November.
    4. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
    5. J. L. Knight & S. E. Satchell & K. C. Tran, 1995. "Statistical modelling of asymmetric risk in asset returns," Applied Mathematical Finance, Taylor & Francis Journals, vol. 2(3), pages 155-172.
    6. Shlomo Benartzi & Richard H. Thaler, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, Oxford University Press, vol. 110(1), pages 73-92.
    7. Sugden, Robert, 2003. "Reference-dependent subjective expected utility," Journal of Economic Theory, Elsevier, vol. 111(2), pages 172-191, August.
    8. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    9. George Wu & Richard Gonzalez, 1996. "Curvature of the Probability Weighting Function," Management Science, INFORMS, vol. 42(12), pages 1676-1690, December.
    10. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
    11. Tversky, Amos & Kahneman, Daniel, 1992. "Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    12. Hilton, Ronald W., 1988. "Risk attitude under two alternative theories of choice under risk," Journal of Economic Behavior & Organization, Elsevier, vol. 9(2), pages 119-136, March.
    13. George Wu & Richard Gonzalez, 1999. "Nonlinear Decision Weights in Choice Under Uncertainty," Management Science, INFORMS, vol. 45(1), pages 74-85, January.
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    Cited by:

    1. Greg Davies, 2006. "Rethinking Risk Attitude: Aspiration as Pure Risk," Theory and Decision, Springer, vol. 61(2), pages 159-190, September.
    2. Davies, G.B., 2005. "Rethinking Risk: Aspiration as Pure Risk," Cambridge Working Papers in Economics 0507, Faculty of Economics, University of Cambridge.

    More about this item

    Keywords

    Risk-Premium; Cumulative Prospect Theory; Loss Aversion; Decision Weights; Utility Curvature;

    JEL classification:

    • D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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