Consistent mean-variance preferences

W. Henry Chiu

Oxford Economic Papers, 2011, vol. 63, issue 2, 398-418

Abstract: Mean-variance utility functions exhibiting a certain set of properties underpin a large body of financial and economic theories. This paper provides a firm choice-theoretic foundation for such a function. Under the assumption that preferences over distributions are utility-representable, we show that the preferences can be represented by a differentiable mean-variance utility function if and only if the preference functional is L p -Fréchet differentiable (for ) and the local utility function is quadratic for all distributions. Assuming the conditions for such a mean-variance utility function, we further identify easily interpretable necessary and sufficient conditions on the preferences for each of the properties that the mean-variance utility function is commonly assumed to exhibit in applications of the mean-variance approach. In the light of the characterizations, it is also shown that the apparent inconsistency demonstrated by Borch in a mean-variance model can be ruled out by appropriate restrictions on the mean-variance utility function. Copyright 2011 Oxford University Press 2010 All rights reserved, Oxford University Press.

Date: 2011
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