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

Helga Fehr-Duda () and Thomas Epper
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Helga Fehr-Duda: Institute for Environmental Decisions, ETH Zürich, 8092 Zürich, Switzerland

Annual Review of Economics, 2012, vol. 4, issue 1, 567-593

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.

Keywords: risk preferences; rank-dependent utility; cumulative prospect theory; disappointment aversion; probability weighting (search for similar items in EconPapers)
JEL-codes: C81 C90 D01 D81 (search for similar items in EconPapers)
Date: 2012
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Citations: View citations in EconPapers (112)

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