Optimizing S-Shaped Utility and Implications for Risk Management

29 Pages Posted: 7 Feb 2018

See all articles by John Armstrong

John Armstrong

King's College London

Damiano Brigo

Imperial College London - Department of Mathematics

Date Written: January 29, 2018

Abstract

We consider market players with tail-risk-seeking behaviour as exemplified by the S-shaped utility introduced by Kahneman and Tversky. We argue that risk measures such as value at risk (VaR) and expected shortfall (ES) are ineffective in constraining such players. We show that, in many standard market models, product design aimed at utility maximization is not constrained at all by VaR or ES bounds: the maximized utility corresponding to the optimal payoff is the same with or without ES constraints. By contrast we show that, in reasonable markets, risk management constraints based on a second more conventional concave utility function can reduce the maximum S-shaped utility that can be achieved by the investor, even if the constraining utility function is only rather modestly concave. It follows that product designs leading to unbounded S-shaped utilities will lead to unbounded negative expected constraining utilities when measured with such conventional utility functions. To prove these latter results we solve a general problem of optimizing an investor expected utility under risk management constraints where both investor and risk manager have conventional concave utility functions, but the investor has limited liability. We illustrate our results throughout with the example of the Black--Scholes option market. These results are particularly important given the historical role of VaR and that ES was endorsed by the Basel committee in 2012-2013.

Keywords: optimal product design under risk constraints, value at risk constraints, expected shortfall constraints, concave utility constraints, S-shaped utility maximization, limited liability investors, tail risk seeking investors, effective risk constraints, concave utility risk constraints

JEL Classification: D81, G11, G13

Suggested Citation

Armstrong, John and Brigo, Damiano, Optimizing S-Shaped Utility and Implications for Risk Management (January 29, 2018). Available at SSRN: https://ssrn.com/abstract=3112663 or http://dx.doi.org/10.2139/ssrn.3112663

John Armstrong

King's College London ( email )

Strand
London, WC2R 2LS
United Kingdom

HOME PAGE: http://https://nms.kcl.ac.uk/john.armstrong/

Damiano Brigo (Contact Author)

Imperial College London - Department of Mathematics ( email )

South Kensington Campus
London SW7 2AZ, SW7 2AZ
United Kingdom

HOME PAGE: http://www.imperial.ac.uk/people/damiano.brigo

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