The text book to this class is

available at www.springer.com

On the book's homepage at

www.financial-economics.de there is
further material available to this
lecture, e.g. corrections and updates.
 Financial Economics
A Concise Introduction to Classical and Behavioral Finance
Chapter 2

Thorsten Hens and Marc Oliver Rieger

Swiss Banking Institute, University of Zurich / BWL, University of Trier

July 31, 2010

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 1 / 57

Decision Theory

Decision Theory
“As soon as questions of will or decision or reason or choice
of action arise, human science is at a loss.” Noam Chomsky

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 2 / 57

Decision Theory

Decisions

Two central questions of Decision Theory:

Prescriptive (rational) approach: How rational decisions should be
made
Descriptive (behavioral) approach: Model the actual decisions
made by individuals.
More in the book on page 15.
In this book choices between alternatives involving risk and
uncertainty.
Risk means here that a decision leads to consequences that are not
precisely predictable, but follow a known probability distribution.
Uncertainty or ambiguity means that this probability distribution
is at least partially unknown to the decision maker.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 3 / 57

Decision Theory

Decisions

Two central questions of Decision Theory:

Prescriptive (rational) approach: How rational decisions should be
made
Descriptive (behavioral) approach: Model the actual decisions
made by individuals.
More in the book on page 15.
In this book choices between alternatives involving risk and
uncertainty.
Risk means here that a decision leads to consequences that are not
precisely predictable, but follow a known probability distribution.
Uncertainty or ambiguity means that this probability distribution
is at least partially unknown to the decision maker.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 3 / 57

Decision Theory
Fundamental Concepts

Preference Relations between Lotteries

A lottery is a given set of states together with their respective
outcomes and probabilities.
A preference relation is a set of rules that states how we make
pairwise decisions between lotteries.
Example (see page 16 in the book):

oo Boom: payoff a1
ooo
prob1
oo
oOoOO
OOO
O
prob2 OO
Recession: payoff a2

State preference approach:

state probability stock bond
Boom prob1 a1s a1b
Recession prob2 a2s a2b
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 4 / 57
Decision Theory
Fundamental Concepts

Preference Relations between Lotteries

A lottery is a given set of states together with their respective
outcomes and probabilities.
A preference relation is a set of rules that states how we make
pairwise decisions between lotteries.
Example (see page 16 in the book):

oo Boom: payoff a1
ooo
prob1
oo
oOoOO
OOO
O
prob2 OO
Recession: payoff a2

State preference approach:

state probability stock bond
Boom prob1 a1s a1b
Recession prob2 a2s a2b
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 4 / 57
Decision Theory
Fundamental Concepts

Preference Relations between Lotteries

Lottery approach: add the probabilities of all states where our

asset has the same payoff:
X
pc = probi .
{i=1,...,S | ai =c}

A preference compares lotteries.

A Â B: we prefer lottery A over B.
A ∼ B: we are indifferent between A and B.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 5 / 57

Decision Theory
Fundamental Concepts

Preference Relation

Definition
A preference relation º on P satisfies the following conditions:
(i) It is complete, i.e., for all lotteries A, B ∈ P, either A º B or
B º A or both.
(ii) It is transitive, i.e., for all lotteries A, B, C ∈ P with A º B and
B º C we have A º C .
More in the book on page 17.

Woody Allen:
Money is better than poverty, if only for financial reasons.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 6 / 57

Decision Theory
Fundamental Concepts

State Dominance

Definition
If, for all states s = 1, . . . S, we have asA ≥ asB and there is at least one
state s ∈ {1, . . . , S} with asA > asB , then we say that A state
dominates B. We sometimes write A ºSD B.
We say that a preference relation º respects (or is compatible with)
state dominance if A ºSD B implies A º B. If º does not respect
state dominance, we say that it violates state dominance.
More in the book on page 18.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 7 / 57

Decision Theory
Fundamental Concepts

Utility Functional

Definition
Let U be a map that assigns a real number to every lottery. We say
that U is a utility functional for the preference relation º if for every
pair of lotteries A and B, we have U(A) ≥ U(B) if and only if A º B.
In the case of state independent preference relations, we can
understand U as a map that assigns a real number to every probability
measure on the set of possible outcomes, i.e., U : P → R.
More in the book on page 19.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 8 / 57

Decision Theory
Expected Utility Theory

Origins of Expected Utility Theory

The concept of probabilities was developed in the 17th century by

Pierre de Fermat, Blaise Pascal and Christiaan Huygens, among
others.
Expected value of a lottery A having outcomes xi with
probabilities pi : X
E(A) = xi pi .
i

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 9 / 57

Decision Theory
Expected Utility Theory

St. Petersburg Paradox

Daniel Bernoulli:
After paying a fixed entrance fee, a fair coin is tossed repeatedly until
a “tails” first appears. This ends the game. If the number of times the
coin is tossed until this point is k, you win 2k−1 ducats.

pk = P(“head” on 1st toss) · P(“head” on 2nd toss) · · ·

· · · P(“tail” on k-th toss)
¡ 1 ¢k
= 2 .
∞ ∞ µ ¶k X ∞
k−1 1 1
X X
E(A) = xk pk = 2 = = +∞.
2 2
k=1 k=1 k=1

Most people would be willing to pay not more than a couple of ducats.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 10 / 57

Decision Theory
Expected Utility Theory

St. Petersburg Paradox

Daniel Bernoulli:
After paying a fixed entrance fee, a fair coin is tossed repeatedly until
a “tails” first appears. This ends the game. If the number of times the
coin is tossed until this point is k, you win 2k−1 ducats.

pk = P(“head” on 1st toss) · P(“head” on 2nd toss) · · ·

· · · P(“tail” on k-th toss)
¡ 1 ¢k
= 2 .
∞ ∞ µ ¶k X ∞
k−1 1 1
X X
E(A) = xk pk = 2 = = +∞.
2 2
k=1 k=1 k=1

Most people would be willing to pay not more than a couple of ducats.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 10 / 57

Decision Theory
Expected Utility Theory

St. Petersburg Lottery

coin toss payoff

Daniel Bernoulli noticed, it is not at all clear why twice the money
should always be twice as good.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 11 / 57

Decision Theory
Expected Utility Theory

St. Petersburg Paradox

In Bernoulli’s own words:

“There is no doubt that a gain of one thousand ducats is more
significant to the pauper than to a rich man though both gain the
same amount.”
Utility function:
utility

money

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 12 / 57

Decision Theory
Expected Utility Theory

St. Petersburg Paradox

In Bernoulli’s own words:

“There is no doubt that a gain of one thousand ducats is more
significant to the pauper than to a rich man though both gain the
same amount.”
Utility function:
utility

money

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 12 / 57

Decision Theory
Expected Utility Theory

St. Petersburg Paradox

We want to maximize the expected value of the utility, in other
words, our utility functional becomes
X
U(p) = E(u) = u(xi )pi ,
i

This resolves the St. Petersburg Paradox.

Assume u(x) := ln(x), then
µ ¶k
X X 1
EUT (Lottery) = u(xk )pk = ln(2k−1 )
2
k k
Xk −1
= (ln 2) < +∞.
2k
k

This is caused by the “diminishing marginal utility of money”, see

in the book on page 24.
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 13 / 57
Decision Theory
Expected Utility Theory

Definitions

Definition (Concavity)
We call a function u : R → R concave on the interval (a, b) (which
might be R) if for all x1 , x2 ∈ (a, b) and λ ∈ (0, 1) the following
inequality holds:

λu(x1 ) + (1 − λ)u(x2 ) ≤ u (λx1 + (1 − λ)x2 ) .

We call u strictly concave if the above inequality is always strict (for

x1 6= x2 ).

Definition (Risk-averse behavior)

We call a person risk-averse if he prefers the expected value of every
lottery over the lottery itself.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 14 / 57

Decision Theory
Expected Utility Theory

A Strictly Concave Function

u(x0 )
λu(x1 ) + (1 − λ)u(x2 )

x1 x0 x2
x0 = λx1 + (1 − λ)x2

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 15 / 57

Decision Theory
Expected Utility Theory

Definitions

Definition (Convexity)
We call a function u : R → R convex on the interval (a, b) if for all
x1 , x2 ∈ (a, b) and λ ∈ (0, 1) the following inequality holds:

λu(x1 ) + (1 − λ)u(x2 ) ≥ u(λx1 + (1 − λ)x2 ).

We call u strictly convex if the above inequality is always strict (for

x1 6= x2 ).

Definition (Risk-seeking behavior)

We call a person risk-seeking if he prefers every lottery over its
expected value.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 16 / 57

Decision Theory
Expected Utility Theory

Propositions

Proposition
If u is strictly concave, then a person described by the Expected Utility
Theory with the utility function u is risk-averse. If u is strictly convex,
then a person described by the Expected Utility Theory with the utility
function u is risk-seeking.

U is fixed only up to monotone transformations and u only up to

positive affine transformations:
Proposition
Let λ > 0 and c ∈ R. If u is a utility function that corresponds to the
preference relation º, i.e., A º B implies U(A) ≥ U(B), then
v (x) := λu(x) + c is also a utility function corresponding to º.

More in the book on page 27.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 17 / 57
Decision Theory
Expected Utility Theory

Propositions

Proposition
If u is strictly concave, then a person described by the Expected Utility
Theory with the utility function u is risk-averse. If u is strictly convex,
then a person described by the Expected Utility Theory with the utility
function u is risk-seeking.

U is fixed only up to monotone transformations and u only up to

positive affine transformations:
Proposition
Let λ > 0 and c ∈ R. If u is a utility function that corresponds to the
preference relation º, i.e., A º B implies U(A) ≥ U(B), then
v (x) := λu(x) + c is also a utility function corresponding to º.

More in the book on page 27.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 17 / 57
Decision Theory
Expected Utility Theory

Axiomatic Definition

We can derive EUT from a set of much simpler assumptions on an

individual’s decisions.

Axiom (Completeness)
For every pair of possible alternatives, A, B, either A ≺ B, A ∼ B or
A Â B holds.

Axiom (Transitivity)
For every A,B,C with A ¹ B and B ¹ C , we have A ¹ C .

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 18 / 57

Decision Theory
Expected Utility Theory

Axiomatic Definition

We can derive EUT from a set of much simpler assumptions on an

individual’s decisions.

Axiom (Completeness)
For every pair of possible alternatives, A, B, either A ≺ B, A ∼ B or
A Â B holds.

Axiom (Transitivity)
For every A,B,C with A ¹ B and B ¹ C , we have A ¹ C .

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 18 / 57

Decision Theory
Expected Utility Theory

Axiomatic Definition

We can derive EUT from a set of much simpler assumptions on an

individual’s decisions.

Axiom (Completeness)
For every pair of possible alternatives, A, B, either A ≺ B, A ∼ B or
A Â B holds.

Axiom (Transitivity)
For every A,B,C with A ¹ B and B ¹ C , we have A ¹ C .

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 18 / 57

Decision Theory
Expected Utility Theory

The Cycle of the “Lucky Hans”, Violating Transitivity

Gold

Nothing Horse

Grindstone Cow

Goose Pig

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 19 / 57

Decision Theory
Expected Utility Theory

Axiomatic Definition

Definition
Let A and B be lotteries and λ ∈ [0, 1], then λA + (1 − λ)B denotes a
new combined lottery where with probability λ the lottery A is played,
and with probability 1 − λ the lottery B is played.

An example can be found in the book on page 31.

Axiom (Independence)
Let A and B be two lotteries with A Â B, and let λ ∈ (0, 1] then for
any lottery C , it must hold

λA + (1 − λ)C Â λB + (1 − λ)C .

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 20 / 57

Decision Theory
Expected Utility Theory

Axiomatic Definition

Definition
Let A and B be lotteries and λ ∈ [0, 1], then λA + (1 − λ)B denotes a
new combined lottery where with probability λ the lottery A is played,
and with probability 1 − λ the lottery B is played.

An example can be found in the book on page 31.

Axiom (Independence)
Let A and B be two lotteries with A Â B, and let λ ∈ (0, 1] then for
any lottery C , it must hold

λA + (1 − λ)C Â λB + (1 − λ)C .

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 20 / 57

Decision Theory
Expected Utility Theory

Axiomatic Definition

Axiom (Continuity)
Let A, B, C be lotteries with A º B º C then there exists a
probability p such that B ∼ pA + (1 − p)C .

Theorem (Expected Utility Theory)

A preference relation that satisfies the Completeness Axiom 1, the
Transitivity Axiom 2, the Independence Axiom 3 and the Continuity
Axiom 4, can be represented by an EUT functional. EUT always
satisfies these axioms.
The proof can be found in the book on page 33.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 21 / 57

Decision Theory
Expected Utility Theory

Axiomatic Definition

Axiom (Continuity)
Let A, B, C be lotteries with A º B º C then there exists a
probability p such that B ∼ pA + (1 − p)C .

Theorem (Expected Utility Theory)

A preference relation that satisfies the Completeness Axiom 1, the
Transitivity Axiom 2, the Independence Axiom 3 and the Continuity
Axiom 4, can be represented by an EUT functional. EUT always
satisfies these axioms.
The proof can be found in the book on page 33.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 21 / 57

Decision Theory
Expected Utility Theory

Which Utility Functions are “Suitable”?

Risk aversion measure:

u 00 (x)
r (x) := − ,
u 0 (x)

first introduced by J.W. Pratt.

The larger r , the more a person is risk-averse.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 22 / 57

Decision Theory
Expected Utility Theory

Which Utility Functions are “Suitable”?

Proposition
Let p be the outcome distribution of a lottery with E(p) = 0, in other
words, p is a fair bet. Let w be the wealth level of the person, then,
neglecting higher order terms in r (w ) and p,
µ ¶
1
EUT (w + p) = u w − var(p)r (w ) ,
2

where var(p) denotes the variance of p. We could say that the “risk
premium”, i.e., the amount the person is willing to pay for an
insurance against a fair bet, is proportional to r (w ).

The proof can be found in the book on page 37.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 23 / 57

Decision Theory
Expected Utility Theory

CARA (Constant Absolute Risk Aversion)

One standard assumption: risk aversion measure r is constant for

all wealth levels.
Example:
u(x) := −e−Ax .
We can verify this by computing

u 00 (x) A2 e−Ax
r (x) = − = = A.
u 0 (x) Ae−Ax

Realistic values: A ≈ 0.0001.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 24 / 57

Decision Theory
Expected Utility Theory

CRRA (Constant Relative Risk Aversion)

Another standard approach: r (x) should be proportional to x.

Relative risk aversion:
u 00 (x)
rr (x) := xr (x) = −x
u 0 (x)

is constant for all x.

Examples:

xR
u(x) := , where R < 1, R 6= 0,
R
u(x) := ln x.

Typical values for R are between −1 and −3.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 25 / 57

Decision Theory
Expected Utility Theory

HARA (Hyperbolic Absolute Risk Aversion)

Generalization of the classes of utility functions.

All functions where the reciprocal of absolute risk aversion,
T := 1/r (x), is an affine function of x.

Proposition
A function u : R → R is HARA if and only if it is an affine
transformation of one of these functions:

(a + bx)(b−1)/b
v1 (x) := ln(x + a), v2 (x) := −ae−x/a , v3 (x) := ,
b−1
where a and b are arbitrary constants (b 6∈ {0, 1} for v3 ). If we define
b := 1 for v1 and b := 0 for v2 , we have in all three cases T = a + bx.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 26 / 57

Decision Theory
Expected Utility Theory

Classes of Utility Functions

Class of utilities Definition ARA r (x) RRA rr (x) Special properties
Logarithmic ln(x + c), c ≥ 0 decr. const. “Bernoulli utility”
1 xα, risk-averse if α < 1,
Power α
α 6= 0 decr. const.
bounded if α < 0
bounded, monotone
Quadratic x − αx 2 , α > 0 incr. incr.
only up to x = (2α)−1
Exponential −e−αx , α > 0 const. incr. bounded

“Super St. Petersburg Paradox”, see in the book on page 41.

Theorem (St. Petersburg Lottery)
Let p be the outcome distribution of a lottery. Let u : R → R be a
utility function.
R
(i) If u is bounded, then EUT (p) := u(x) dp < ∞.
(ii) Assume that E(p) < ∞. If u is asymptotically concave, i.e.,
there is a C > 0 such that u is concave on the interval [C , +∞),
then EUT (p) < ∞.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 27 / 57

Decision Theory
Expected Utility Theory

Classes of Utility Functions

Class of utilities Definition ARA r (x) RRA rr (x) Special properties
Logarithmic ln(x + c), c ≥ 0 decr. const. “Bernoulli utility”
1 xα, risk-averse if α < 1,
Power α
α 6= 0 decr. const.
bounded if α < 0
bounded, monotone
Quadratic x − αx 2 , α > 0 incr. incr.
only up to x = (2α)−1
Exponential −e−αx , α > 0 const. incr. bounded

“Super St. Petersburg Paradox”, see in the book on page 41.

Theorem (St. Petersburg Lottery)
Let p be the outcome distribution of a lottery. Let u : R → R be a
utility function.
R
(i) If u is bounded, then EUT (p) := u(x) dp < ∞.
(ii) Assume that E(p) < ∞. If u is asymptotically concave, i.e.,
there is a C > 0 such that u is concave on the interval [C , +∞),
then EUT (p) < ∞.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 27 / 57

Decision Theory
Expected Utility Theory

Classes of Utility Functions

Class of utilities Definition ARA r (x) RRA rr (x) Special properties
Logarithmic ln(x + c), c ≥ 0 decr. const. “Bernoulli utility”
1 xα, risk-averse if α < 1,
Power α
α 6= 0 decr. const.
bounded if α < 0
bounded, monotone
Quadratic x − αx 2 , α > 0 incr. incr.
only up to x = (2α)−1
Exponential −e−αx , α > 0 const. incr. bounded

“Super St. Petersburg Paradox”, see in the book on page 41.

Theorem (St. Petersburg Lottery)
Let p be the outcome distribution of a lottery. Let u : R → R be a
utility function.
R
(i) If u is bounded, then EUT (p) := u(x) dp < ∞.
(ii) Assume that E(p) < ∞. If u is asymptotically concave, i.e.,
there is a C > 0 such that u is concave on the interval [C , +∞),
then EUT (p) < ∞.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 27 / 57

Decision Theory
Expected Utility Theory

Measuring the Utility Function

Midpoint certainty equivalent method.

A subject is asked to state a monetary equivalent to a lottery
with two outcomes.
Each with probability 1/2.
Such a monetary equivalent is called a Certainty Equivalent (CE).
Set u(x0 ) := 0 and u(x1 ) := 1, then u(CE ) = 0.5.
Set x0.5 := CE and iterate this method by comparing a lottery
with the outcomes x0 and x0.5 and probabilities 1/2 each etc.
An example can be found in the book on page 44.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 28 / 57

Decision Theory
Mean-Variance Theory

Definition and Fundamental Properties

Introduced in 1952 by Markowitz
Key idea: measure the risk of an asset by only one parameter, the
variance σ.

Definition (Mean-Variance approach)

A mean-variance utility function u is a utility function u : R × R+ → R
which corresponds to a utility functional U : P → R that only depends
on the mean and the variance of a probability measure p, i.e.,
U(p) = u(E(p), var(p)).

Definition
A mean-variance utility function u : R × R+ → R is called monotone if
u(µ, σ) ≥ u(ν, σ) for all µ, ν, σ with µ > ν. It is called strictly
monotone if even u(µ, σ) > u(ν, σ).
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 29 / 57
Decision Theory
Mean-Variance Theory

Definition and Fundamental Properties

Introduced in 1952 by Markowitz
Key idea: measure the risk of an asset by only one parameter, the
variance σ.

Definition (Mean-Variance approach)

A mean-variance utility function u is a utility function u : R × R+ → R
which corresponds to a utility functional U : P → R that only depends
on the mean and the variance of a probability measure p, i.e.,
U(p) = u(E(p), var(p)).

Definition
A mean-variance utility function u : R × R+ → R is called monotone if
u(µ, σ) ≥ u(ν, σ) for all µ, ν, σ with µ > ν. It is called strictly
monotone if even u(µ, σ) > u(ν, σ).
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 29 / 57
Decision Theory
Mean-Variance Theory

Definition and Fundamental Properties

Introduced in 1952 by Markowitz
Key idea: measure the risk of an asset by only one parameter, the
variance σ.

Definition (Mean-Variance approach)

A mean-variance utility function u is a utility function u : R × R+ → R
which corresponds to a utility functional U : P → R that only depends
on the mean and the variance of a probability measure p, i.e.,
U(p) = u(E(p), var(p)).

Definition
A mean-variance utility function u : R × R+ → R is called monotone if
u(µ, σ) ≥ u(ν, σ) for all µ, ν, σ with µ > ν. It is called strictly
monotone if even u(µ, σ) > u(ν, σ).
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 29 / 57
Decision Theory
Mean-Variance Theory

Definition and Fundamental Properties

Definition
A mean-variance utility function u : R × R+ → R is called
variance-averse if u(µ, σ) ≥ u(µ, τ ) for all µ, τ, σ with τ > σ. It is
called strictly variance-averse if u(µ, σ) > u(µ, τ ) for all µ, τ, σ with
τ > σ.

Remark
Let u be a mean-variance function. Then the preference induced by u
is risk-averse if and only if u(µ, σ) < u(µ, 0) for all µ, σ. The
preference is risk-seeking if and only if u(µ, σ) > u(µ, 0).

Example:
u1 (µ, σ) := µ − σ 2 .

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 30 / 57

Decision Theory
Mean-Variance Theory

Definition and Fundamental Properties

Definition
A mean-variance utility function u : R × R+ → R is called
variance-averse if u(µ, σ) ≥ u(µ, τ ) for all µ, τ, σ with τ > σ. It is
called strictly variance-averse if u(µ, σ) > u(µ, τ ) for all µ, τ, σ with
τ > σ.

Remark
Let u be a mean-variance function. Then the preference induced by u
is risk-averse if and only if u(µ, σ) < u(µ, 0) for all µ, σ. The
preference is risk-seeking if and only if u(µ, σ) > u(µ, 0).

Example:
u1 (µ, σ) := µ − σ 2 .

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 30 / 57

Decision Theory
Mean-Variance Theory

Success and Limitation

Main advantage of the mean-variance approach: simplicity.

Allows us to use (µ, σ)-diagrams.
Nevertheless certain problems and limitations of the
Mean-Variance Theory.
Example: the following two assets have identical mean and
variance:
payoff 0e 1010e
A :=
probability 99.5% 0.05%
payoff -1000e 10e
B :=
probability 0.05% 99.5%

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 31 / 57

Decision Theory
Mean-Variance Theory

Success and Limitation

There are strong theoretical limitations:

Theorem (Mean-Variance Paradox)
For every continuous mean-variance utility function u(µ, σ) which
corresponds to a risk-averse preference, there exist two assets A and B
where A state dominates B, but B is preferred over A.

Proof and Corollary can be found in the book on page 50 and 51.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 32 / 57

Decision Theory
Mean-Variance Theory

Success and Limitation

There are strong theoretical limitations:

Theorem (Mean-Variance Paradox)
For every continuous mean-variance utility function u(µ, σ) which
corresponds to a risk-averse preference, there exist two assets A and B
where A state dominates B, but B is preferred over A.

Proof and Corollary can be found in the book on page 50 and 51.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 32 / 57

Decision Theory
Prospect Theory

Prospect Theory

How do people really decide?

As if they were maximizing their expected utility?
Or as if they were following the mean-variance approach?

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 33 / 57

Decision Theory
Prospect Theory

Example: Allais Paradox

Consider four lotteries A, B, C and D.

In each lottery a random number is drawn from the set
{1, 2, . . . , 100} where each number occurs with the same
probability of 1%.
The lotteries assign outcomes to every of these 100 possible
numbers (states).
The test persons are asked to decide between the two lotteries A
and B and then between C and D. Most people prefer B over A
and C over D.
This behavior is not rational and violates the Independence
Axiom.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 34 / 57

Decision Theory
Prospect Theory

The four lotteries of Allais’ Paradox

State 1–33 34–99 100

Lottery A
Outcome 2500 2400 0
State 1–100
Lottery B
Outcome 2400
State 1–33 34–100
Lottery C
Outcome 2500 0
State 1–33 34–99 100
Lottery D
Outcome 2400 0 2400

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 35 / 57

Decision Theory
Prospect Theory

Observed Facts

People tend to buy insurances (risk-averse behavior) and take

part in lotteries (risk-seeking behavior) at the same time.
People are usually risk-averse even for small-stake gambles and
large initial wealth. This would predict a degree on risk aversion
for high-stake gambles that is far away from standard behavior.
Does this mean, that the “homo economicus” is dead and that all
models of humans as rational deciders are obsolete?
Is “science at a loss” when it comes to people’s decisions?
The “homo economicus” is still a central concept, and there are
modifications that describe human decisions.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 36 / 57

Decision Theory
Prospect Theory

Observed Facts

Framing effect
in gains: people behave risk-averse
losses: people tend to behave risk-seeking.
People tend to systematically overweight small probabilities.
Risk attitudes depending on probability and frame:
Losses Gains
Medium probabilities risk-seeking risk-averse
Low probabilities risk-averse risk-seeking

We explain Allais’ Paradox with this idea.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 37 / 57

Decision Theory
Prospect Theory

Original Prospect Theory

Kahneman and Tversky

Instead of the final wealth we consider the gain and loss (framing
effect) instead of the real probabilities we consider weighted
probabilities
Subjective utility:
n
X
PT (A) := v (xi )w (pi ),
i=1

where v : R → R is the value function, defined on losses and

gains. w : [0, 1] → [0, 1] is the probability weighting function.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 38 / 57

Decision Theory
Prospect Theory

Original Prospect Theory

v is continuous and monotone increasing.

The function v is strictly concave for values larger than zero, i.e.,
in gains, but strictly convex for values less than zero, i.e., in
losses.
At zero, the function v is “steeper” in losses than in gains, i.e., its
slope at −x is bigger than its slope at x.
The function w is continuous and monotone increasing.
w (p) > p for small values of p > 0 (probability overweighting)
and w (p) < p for large values of p < 1 (probability
underweighting), w (0) = 0, w (1) = 1 (no weighting for sure
outcomes).

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 39 / 57

Decision Theory
Prospect Theory

Original Prospect Theory

value weighted prob.

relative
return

1 prob.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 40 / 57

Decision Theory
Prospect Theory

Original Prospect Theory

If we have many events, all of them will probably be overweighted

and the sum of the weighted probabilities will be large.
Alternative formulation of Prospect Theory that fixes the problem:
Pn
i=1 v (xi )w (pi )
PT (A) = P n .
i=1 w (pi )

More about this and the four-fold pattern in the book on page 58.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 41 / 57

Decision Theory
Prospect Theory

Original Prospect Theory

Definition (Stochastic dominance)

A lottery A is stochastically dominant over a lottery B if, for every
payoff x, the probability to obtain more than x is larger or equal for A
than for B and there is at least some payoff x such that this
probability is strictly larger.

An example can be found in the book on page 59.

PT violates stochastic dominance.
Another limitation: PT can only be applied for finitely many
outcomes.
In finance, however, we are interested ininfinitely many outcomes.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 42 / 57

Decision Theory
Prospect Theory

Original Prospect Theory

Definition (Stochastic dominance)

A lottery A is stochastically dominant over a lottery B if, for every
payoff x, the probability to obtain more than x is larger or equal for A
than for B and there is at least some payoff x such that this
probability is strictly larger.

An example can be found in the book on page 59.

PT violates stochastic dominance.
Another limitation: PT can only be applied for finitely many
outcomes.
In finance, however, we are interested ininfinitely many outcomes.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 42 / 57

Decision Theory
Prospect Theory

Cumulative Prospect Theory

Key idea: Replace the probabilities by differences of cumulative

probabilities.
Definition (Cumulative Prospect Theory)
For a lottery A with n outcomes x1 , . . . , xP
n and the probabilities
p1 , . . . , pn where x1 < x2 < · · · < xn and ni=1 pi = 1 we define
n
X
CPT (A) := (w (Fi ) − w (Fi−1 )) v (xi ), (1)
i=1
Pi
where F0 := 0 and Fi := j=1 pj for i = 1, . . . , n.

How this formula is connected to Prospect Theory is written in the

book on page 60.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 43 / 57

Decision Theory
Prospect Theory

Cumulative Prospect Theory

On average, events are neither over- nor underweighted in CPT,
see page 61 in the book.
Prototypical example of a value function v :
(
xα , x ≥ 0,
v (x) := β
(2)
−λ(−x) , x < 0,

Value and weighting function:

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 44 / 57

Decision Theory
Prospect Theory

Cumulative Prospect Theory

Probability weighting function w :
pγ
w (p) := ,
(p γ + (1 − p)γ )1/γ
Experimental values:
Estimate Estimate
Study
for α,β for γ, δ
Tversky and Kahneman
gains: 0.88 0.61
losses: 0.88 0.69
Camerer and Ho 0.37 0.56
Tversky and Fox 0.88 0.69
Wu and Gonzalez
gains: 0.52 20.71
Abdellaoui
gains: 0.89 0.60
losses: 0.92 0.70
Bleichrodt and Pinto 0.77 0.67/0.55
Kilka and Weber 0.76-1.00 0.30-0.51

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 45 / 57

Decision Theory
Prospect Theory

Cumulative Prospect Theory

Extend CPT to arbitrary lotteries.

we can describe lotteries by probability measures, see
Appendix A.4 for details.

Definition
Let p be an arbitrary probability measure, then the generalized form of
CPT reads as
Z +∞ µ ¶
d
CPT (p) := v (x) w (F (t))|t=x dx, (3)
−∞ dt

where Z t
F (t) := dp.
−∞

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 46 / 57

Decision Theory
Prospect Theory

Cumulative Prospect Theory

Extend CPT to arbitrary lotteries.

we can describe lotteries by probability measures, see
Appendix A.4 for details.

Definition
Let p be an arbitrary probability measure, then the generalized form of
CPT reads as
Z +∞ µ ¶
d
CPT (p) := v (x) w (F (t))|t=x dx, (3)
−∞ dt

where Z t
F (t) := dp.
−∞

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 46 / 57

Decision Theory
Prospect Theory

Cumulative Prospect Theory

Proposition
CPT does not violate stochastic dominance, i.e., if A is stochastic
dominant over B then CPT (A) > CPT (B).

The proof can be found in the book on page 64.

Since the value function has the same convex-concave shape in
CPT as in PT, the four-fold pattern of risk-attitudes can be
explained in exactly the same manner.
Choice of value and weighting function, see book on page 67.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 47 / 57

Decision Theory
Prospect Theory

Cumulative Prospect Theory

Proposition
CPT does not violate stochastic dominance, i.e., if A is stochastic
dominant over B then CPT (A) > CPT (B).

The proof can be found in the book on page 64.

Since the value function has the same convex-concave shape in
CPT as in PT, the four-fold pattern of risk-attitudes can be
explained in exactly the same manner.
Choice of value and weighting function, see book on page 67.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 47 / 57

Decision Theory
Connecting EUT, Mean-Variance Theory and PT

EUT, Mean-Variance Theory and CPT

EUT is the “rational benchmark”. We will use it as a reference of

rational behavior and as a prescriptive theory when we want to
find an objectively optimal decision.
Mean-Variance Theory is the “pragmatic solution”. The theory is
widely used in finance.
CPT model “real life behavior”. We will use it to describe
behavior patterns of investors.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 48 / 57

Decision Theory
Connecting EUT, Mean-Variance Theory and PT

Differences and Agreements of EUT, PT and Mean-Variance

EUT

Rational,
cannot explain
Allais.

γ = 1 and
Quadratic
fixed
utility
N(µ, σ) frame

Problems
with: MV- Includes
paradox, skewed Piecewise framing effect,
distributions. quadratic explains buying
Simplest model. value of lotteries.
function

MV CPT

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 49 / 57

Decision Theory
Ambiguity and Uncertainty?

Ambiguity and Uncertainty

Often probabilities are known. We call this ambiguity or

uncertainty.
Example:
There is an urn with 300 balls. 100 of them are red, 200 are blue
or green. You can pick red or blue and then take one ball (blindly,
of course). If it is of the color you picked, you win 100e, else you
don’t win anything. Which color do you choose?
Most people choose red.
Example:
Same situation, you pick again a color (either red or blue) and
then take a ball. This time, if the ball is not of the color you
picked, you win 100e, else you don’t win anything. Which color
do you choose?
Most people indeed pick red.
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 50 / 57
Decision Theory
Ambiguity and Uncertainty?

Ambiguity and Uncertainty

Often probabilities are known. We call this ambiguity or

uncertainty.
Example:
There is an urn with 300 balls. 100 of them are red, 200 are blue
or green. You can pick red or blue and then take one ball (blindly,
of course). If it is of the color you picked, you win 100e, else you
don’t win anything. Which color do you choose?
Most people choose red.
Example:
Same situation, you pick again a color (either red or blue) and
then take a ball. This time, if the ball is not of the color you
picked, you win 100e, else you don’t win anything. Which color
do you choose?
Most people indeed pick red.
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 50 / 57
Decision Theory
Ambiguity and Uncertainty?

Ambiguity and Uncertainty

Often probabilities are known. We call this ambiguity or

uncertainty.
Example:
There is an urn with 300 balls. 100 of them are red, 200 are blue
or green. You can pick red or blue and then take one ball (blindly,
of course). If it is of the color you picked, you win 100e, else you
don’t win anything. Which color do you choose?
Most people choose red.
Example:
Same situation, you pick again a color (either red or blue) and
then take a ball. This time, if the ball is not of the color you
picked, you win 100e, else you don’t win anything. Which color
do you choose?
Most people indeed pick red.
T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 50 / 57
Decision Theory
Ambiguity and Uncertainty?

Ambiguity and Uncertainty

People go both times for the “sure” option, the option where they
know their probabilities to win.
Uncertainty-aversity, see book on page 81.
People are often not very knowledgeable about the chances and
risks of financial investments.
This explains why many people invest into very few stocks (that
they are familiar with) or even only into the stock of their own
company (even if their company is not performing well).

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 51 / 57

Decision Theory
Time Discounting

Time Discounting

Original utility:
u(t) = u(0)e−δt ,
Classical time discounting leads to a time-consistent preference.
More details in the book on page 82.
Hyperbolic discounting:

u(0)
u(t) =
1 + δt
Quasi-hyperbolic discounting:
½
u(0) , for t = 0,
u(t) = 1 −δt where β > 0.
1+β u(0)e , for t > 0,

An example can be found in the book on page 84.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 52 / 57
Decision Theory
Time Discounting

Rational versus Hyperbolic Time Discounting

discounted utility

e −δt

u(0)
u(t) =
1 + δt

time t

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 53 / 57

References

References

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 54 / 57

References

References I

Abdeallaoui, M. (2000).
Parameter-free elicitation of utilities and probability weighting
functions.
Management Science, 46:1497–1512.
Bleichrodt, H. and Pinto, J. L. (2000).
A parameter-free elicitation of the probability weighting function
in medical decision analysis.
Management science, 46:1485–1496.
Camerer, C. and Ho, T.-H. (1994).
Violations of the betweenness axiom and nonlinearity in
probability.
Journal of Risk and Uncertainty, 8:167–196.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 55 / 57

References

References II

Kilka, M. and Weber, M. (2001).

What determines the shape of the proability weighting function
under uncertainty?
Management Science, 47(12):1712–1726.
Tversky, A. and Fox, C. R. (1995).
Weighing risk and uncertainty.
Psychological Review, 102(2):269–283.
Tversky, A. and Kahneman, D. (1992).
Advances in Prospect Theory: Cumulative representation of
uncertainty.
Journal of Risk and Uncertainty, 5:297–323.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 56 / 57

References

References III

Wu, G. and Gonzalez, R. (1996).

Curvature of the probability weighting function.
Management Science, 42:1676–1690.

T. Hens, M. Rieger (Zürich/Trier) Financial Economics July 31, 2010 57 / 57