When can expected utility handle first-order risk aversion?

Georges Dionne () and Jingyuan Li

No 11-1, Working Papers from HEC Montreal, Canada Research Chair in Risk Management

Abstract: Expected utility functions are limited to second-order (conditional) risk aversion, while non-expected utility functions can exhibit either first-order or second-order (conditional) risk aversion. We extend the concept of orders of conditional risk aversion to orders of conditional dependent risk aversion. We show that first-order conditional dependent risk aversion is consistent with the framework of the expected utility hypothesis. Our theoretical result proposes new insights into economic and financial applications such as the equity premium puzzle, the cost of business cycles, and stock market participation. Our model is compared to the rank-dependent expected utility model.

Keywords: Expected utility theory; first-order conditional dependent risk aversion; background risk; equity premium puzzle; consumption risk in business cycles; coward gambler; stock market participation; rank-dependent expected utility model (search for similar items in EconPapers)
JEL-codes: D81 G10 G11 G12 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2014-09-23
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