Probability and Risk: Foundations and Economic Implications of Probability-Dependent Risk Preferences

Posted: 1 Sep 2012

See all articles by Helga Fehr-Duda

Helga Fehr-Duda

ETH Zürich - Center for Economic Research

Thomas Epper

CNRS - Lille Economics & Managment - UMR 9221; Catholic University of Lille - IESEG School of Management

Date Written: July 2012

Abstract

A large body of evidence has documented that risk preferences depend nonlinearly on outcome probabilities. We discuss the foundations and economic consequences of probability-dependent risk preferences and offer a practitioner's guide to understanding and modeling probability dependence. We argue that probability dependence provides a unifying framework for explaining many real-world phenomena, such as the equity premium puzzle, the long-shot bias in betting markets, and households' underdiversification and their willingness to buy small-scale insurance at exorbitant prices. Recent findings indicate that probability dependence is not just a feature of laboratory data, but is indeed manifest in financial, insurance, and betting markets. The neglect of probability dependence may prevent researchers from understanding and predicting important phenomena.

Suggested Citation

Fehr-Duda, Helga and Epper, Thomas, Probability and Risk: Foundations and Economic Implications of Probability-Dependent Risk Preferences (July 2012). Annual Review of Economics, Vol. 4, pp. 567-593, 2012, Available at SSRN: https://ssrn.com/abstract=2139254 or http://dx.doi.org/10.1146/annurev-economics-080511-110950

Helga Fehr-Duda (Contact Author)

ETH Zürich - Center for Economic Research ( email )

Weinbergstr. 35
Zurich 8092
Switzerland

Thomas Epper

CNRS - Lille Economics & Managment - UMR 9221 ( email )

Lille
France

Catholic University of Lille - IESEG School of Management ( email )

Socle de la Grande Arche
1 Parvis de la Defense
Puteaux, Paris 92800
France

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