Utility Functions whose Parameters depend on Initial Wealth

Christian S. Pedersen and S. E. Satchell

Bulletin of Economic Research, 2003, vol. 55, issue 4, 357-371

Abstract: Conventional one‐period utility functions in Economics assume that initial wealth only enters preferences through the definition of final wealth. Consequently, those utility functions most utilized (i.e., exponential and quadratic) have implausible risk characteristics. The authors characterize a new class of utility function whose risk parameters depend upon initial wealth and obtain several desirable results. In particular, investors with quadratic and exponential utility functions can have decreasing risk aversion, and risky assets in a quadratic utility multi‐asset environment do not have to be inferior as implied by the traditional framework.

Date: 2003
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