Arrow-Pratt Risk Aversion, Risk Premium and Decision Weights

Haim Levy and Moshe Levy ()

Journal of Risk and Uncertainty, 2002, vol. 25, issue 3, 265-90

Abstract: This paper analyzes two issues: (a) the effect of decision-weights on risk premium, and (b) whether risk-aversion characterizes most investors. We theoretically show that cumulative prospect theory decision-weights systematically increase Arrow's (1965) risk premium, and may induce a positive risk premium even in the absence of risk-aversion. However, decision-weights may either increase or reduce Pratt's risk premium. We present three experiments revealing a striking result: a large proportion of the subjects' choices contradicts risk-aversion. This may be due to non-concave preferences, or to decision-weights. This result may have a dramatic impact on equilibrium models in economics and finance. Copyright 2002 by Kluwer Academic Publishers

Date: 2002
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