Utility Functions with Parameters Depending on Initial Wealth

Christian C Pedersen and Stephen E Satchell

Cambridge Working Papers in Economics from Faculty of Economics, University of Cambridge

Abstract: Conventional one-period utility functions in economics assume that initial wealth only enters preferences through the definition of final wealth. As a consequence, those utility functions most utilised (i.e. exponential and quadratic) have implausible risk characteristics. The authors characterise a new class of utility functions whose parameters depend upon initial wealth. Several desirable results are obtained. In particular, investors with quadratic and exponential utility functions can have decreasing risk aversion and will increase their share of the risky asset as they get wealthier. Additionally, the authors show how making parameters depend on initial wealth extends the class of functions which give two- fund separation and can convert the traditional principal-agent problem to one which accounts for observed behaviour of asset managers and pension funds.

Keywords: Initial wealth; Expected utility; Risk aversion (search for similar items in EconPapers)
JEL-codes: D81 G11 (search for similar items in EconPapers)
Date: 1998-10
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Persistent link: https://EconPapers.repec.org/RePEc:cam:camdae:9819

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