Comparative Risk Aversion in RDEU with Applications to Optimal Underwriting of Securities Issuance
51 Pages Posted: 19 Jan 2018 Last revised: 9 Jun 2020
Date Written: December 20, 2019
We provide a characterization of comparative weak risk aversion and comparative RDEU risk aversion for RDEU preferences and, in particular, we correct a claim made by Quiggin (1993) regarding comparative RDEU risk aversion. We then apply the analysis of comparative risk aversion to a problem of optimal design of underwriting contracts in securities issuance. Specifically, in public offerings of equity, an investment banking rm (the underwriter) plays an insurance role: through the underwriting contract, the issuing rm transfers the issue risk to the underwriter, as would an insured to an insurer. We extend a classical model proposed by Mandelker and Raviv (1977) to situations where the issuing rm and the underwriter have RDEU preferences. Assuming that the issuing company's and the underwriter's utility functions are concave and linear, respectively, and that either the underwriter is risk neutral or both the issuing company and underwriter are strongly risk averse, we show that a firm-commitment contract is optimal if and only if the issuing company's probability weighting function dominates the underwriter's.
Keywords: Rank-dependent expected utility, comparative risk aversion, risk sharing, optimal underwriting, firm-commitment contract
JEL Classification: G24, G52, D89
Suggested Citation: Suggested Citation