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The Case of “Less is More”: Modelling Risk-Preference with Expected Downside Risk

Mihály Ormos () and Timotity Dusán ()
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Timotity Dusán: Department of Finance, Budapest University of Technology and Economics, Magyar tudosok krt 2., Budapest, Hungary

The B.E. Journal of Theoretical Economics, 2017, vol. 17, issue 2, 14

Abstract: This paper discusses an alternative explanation for the empirical findings contradicting the positive relationship between risk (variance) and reward (expected return). We show that these contradicting results might be due to the false definition of risk-perception, which we correct by introducing Expected Downside Risk (EDR). The EDR parameter, similar to the Expected Shortfall or Conditional Value-at-Risk, measures the tail risk, however, fits and better explains the utility perception of investors. Our results indicate that when using the EDR as risk measure, both the positive and negative relationship between expected return and risk can be derived under standard conditions (e. g. expected utility theory and positive risk-aversion). Therefore, no alternative psychological explanation or additional boundary condition on utility theory is required to explain the phenomenon. Furthermore, we show empirically that it is a more precise linear predictor of expected return than volatility, both for individual assets and portfolios.

Keywords: asset pricing; variance; conditional value at risk; expected downside risk; utility theory; behavioral finance (search for similar items in EconPapers)
JEL-codes: G02 G12 G17 C53 C62 (search for similar items in EconPapers)
Date: 2017
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