When Can Expected Utility Handle First-Order Risk Aversion?

Posted: 9 Jan 2013 Last revised: 20 Jan 2016

See all articles by Georges Dionne

Georges Dionne

HEC Montreal - Department of Finance

Jingyuan Li

Lingnan University - Department of Finance and Insurance

Date Written: September 24, 2014

Abstract

Expected utility functions are limited to second-order (conditional) risk aversion, while non-expected utility functions can exhibit either first-order or second-order (conditional) risk aversion. We extend the concept of orders of conditional risk aversion to orders of conditional dependent risk aversion. We show that first-order conditional dependent risk aversion is consistent with the framework of the expected utility hypothesis. Our theoretical result proposes new insights into economic and financial applications such as the equity premium puzzle, the cost of business cycles, and stock market participation. Our model is compared to the rank-dependent expected utility model.

Keywords: expected utility theory, first-order conditional dependent risk aversion, background cycles, coward gambler, stock market participation, rank-dependent expected utility model

JEL Classification: D81, G10, G11, G12

Suggested Citation

Dionne, Georges and Li, Jingyuan, When Can Expected Utility Handle First-Order Risk Aversion? (September 24, 2014). Available at SSRN: https://ssrn.com/abstract=2197741 or http://dx.doi.org/10.2139/ssrn.2197741

Georges Dionne

HEC Montreal - Department of Finance ( email )

3000 Chemin de la Cote-Sainte-Catherine
Montreal, Quebec H3T 2A7
Canada
514-340-6596 (Phone)
514-340-5019 (Fax)

HOME PAGE: http://www.hec.ca/gestiondesrisques/

Jingyuan Li (Contact Author)

Lingnan University - Department of Finance and Insurance ( email )

Castle Peak Road
Tuen Mun, New Territories
Hong Kong
China

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