Sufficient conditions of stochastic dominance for general transformations and its application in option strategy

Jianwei Gao and Feng Zhao

No 2017-40, Economics Discussion Papers from Kiel Institute for the World Economy (IfW Kiel)

Abstract: A counterexample is presented to show that the sufficient condition for one transformation dominating another by the second degree stochastic dominance, proposed by Theorem 5 of Levy (Stochastic dominance and expected utility: Survey and analysis, 1992), does not hold. Then, by restricting the monotone property of the dominating transformation, a revised exact sufficient condition for one transformation dominating another is given. Next, the stochastic dominance criteria, proposed by Meyer (Stochastic Dominance and transformations of random variables, 1989) and developed by Levy (Stochastic dominance and expected utility: Survey and analysis, 1992), are extended to the most general transformations. Moreover, such criteria are further generalized to transformations on discrete random variables. Finally, the authors employ this method to analyze the transformations resulting from holding a stock with the corresponding call option.

Keywords: stochastic dominance; transformation; utility theory; option strategy (search for similar items in EconPapers)
JEL-codes: C51 D81 G1 (search for similar items in EconPapers)
Date: 2017
New Economics Papers: this item is included in nep-ore and nep-upt
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