UTILITY THEORY FRONT TO BACK — INFERRING UTILITY FROM AGENTS' CHOICES

Alexander M. G. Cox (), David Hobson () and OBłÓJ Jan ()
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Alexander M. G. Cox: Department of Mathematical Sciences, University of Bath, Bath BA2 7AY, United Kingdom
David Hobson: Department of Statistics, University of Warwick, Coventry CV4 7AL, United Kingdom
OBłÓJ Jan: Mathematical Institute and Oxford–Man Institute of Quantitative Finance, University of Oxford, Oxford OX1 3LB, United Kingdom

International Journal of Theoretical and Applied Finance (IJTAF), 2014, vol. 17, issue 03, 1-44

Abstract: We pursue an inverse approach to utility theory and associated consumption and investment problems. Instead of specifying a utility function and deriving the actions of an agent, we assume that we observe the actions of the agent (i.e. consumption and investment strategies) and ask if it is possible to derive a utility function for which the observed behavior is optimal. We work in continuous time both in a deterministic and stochastic setting. In the deterministic setup, we find that there are infinitely many utility functions generating a given consumption pattern. In the stochastic setting of a geometric Brownian motion market it turns out that the consumption and investment strategies have to satisfy a consistency condition (PDE) if they are to come from a classical utility maximization problem. We show further that important characteristics of the agent such as risk attitudes (e.g., DARA) can be deduced directly from the agent's consumption and investment choices.

Keywords: Consumption and investment problem; utility maximization; inverse problem; consistency condition; duality (search for similar items in EconPapers)
Date: 2014
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Citations: View citations in EconPapers (2)

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DOI: 10.1142/S0219024914500186

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