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The Behavioural Components of Risk Aversion

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  • Davies, G.B.
  • Satchell, S.E.
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    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.

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    File URL: http://www.econ.cam.ac.uk/research/repec/cam/pdf/cwpe0458.pdf
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    Paper provided by Faculty of Economics, University of Cambridge in its series Cambridge Working Papers in Economics with number 0458.

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    Length: 55
    Date of creation: Oct 2004
    Handle: RePEc:cam:camdae:0458
    Note: EM
    Contact details of provider: Web page: http://www.econ.cam.ac.uk/index.htm

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

    Find related papers by 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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    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. 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.
    3. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-291, March.
    4. George Wu & Richard Gonzalez, 1996. "Curvature of the Probability Weighting Function," Management Science, INFORMS, vol. 42(12), pages 1676-1690, December.
    5. Drazen Prelec, 1998. "The Probability Weighting Function," Econometrica, Econometric Society, vol. 66(3), pages 497-528, May.
    6. 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.
    7. George Wu & Richard Gonzalez, 1999. "Nonlinear Decision Weights in Choice Under Uncertainty," Management Science, INFORMS, vol. 45(1), pages 74-85, January.
    8. Kobberling, Veronika & Wakker, Peter P., 2005. "An index of loss aversion," Journal of Economic Theory, Elsevier, vol. 122(1), pages 119-131, May.
    9. 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.
    10. Quiggin, John, 1982. "A theory of anticipated utility," Journal of Economic Behavior & Organization, Elsevier, vol. 3(4), pages 323-343, December.
    11. 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.
    12. Sugden, Robert, 2003. "Reference-dependent subjective expected utility," Journal of Economic Theory, Elsevier, vol. 111(2), pages 172-191, August.
    13. 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.
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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, 09.
    2. Davies, G.B., 2005. "Rethinking Risk: Aspiration as Pure Risk," Cambridge Working Papers in Economics 0507, Faculty of Economics, University of Cambridge.

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