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Arrow-Pratt Risk Aversion, Risk Premium and Decision Weights

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  • Levy, Haim
  • Levy, Moshe

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

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  • Levy, Haim & Levy, Moshe, 2002. "Arrow-Pratt Risk Aversion, Risk Premium and Decision Weights," Journal of Risk and Uncertainty, Springer, vol. 25(3), pages 265-290, November.
    • Handle: RePEc:kap:jrisku:v:25:y:2002:i:3:p:265-90
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    2. Davies, G.B. & Satchell, S.E., 2004. "The Behavioural Components of Risk Aversion," Cambridge Working Papers in Economics 0458, Faculty of Economics, University of Cambridge.
    3. Galarza, Francisco B. & Carter, Michael R., 2010. "Risk Preferences and Demand for Insurance in Peru: A Field Experiment," 2010 Annual Meeting, July 25-27, 2010, Denver, Colorado 61871, Agricultural and Applied Economics Association.
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    5. Galarza, Francisco, 2009. "Risk, Credit, and Insurance in Peru: Field Experimental Evidence," MPRA Paper 17833, University Library of Munich, Germany.
    6. Jakusch, Sven Thorsten & Meyer, Steffen & Hackethal, Andreas, 2019. "Taming models of prospect theory in the wild? Estimation of Vlcek and Hens (2011)," SAFE Working Paper Series 146, Leibniz Institute for Financial Research SAFE, revised 2019.
    7. Palit, Niladri & Brint, Andrew, 2020. "A win-win supply chain solution using project contracts with bargaining games," Operations Research Perspectives, Elsevier, vol. 7(C).
    8. R. Luce, 2010. "Behavioral assumptions for a class of utility theories: A program of experiments," Journal of Risk and Uncertainty, Springer, vol. 41(1), pages 19-37, August.
    9. Mattos, Fabio & Garcia, Philip & Pennings, Joost M.E., 2008. "Probability weighting and loss aversion in futures hedging," Journal of Financial Markets, Elsevier, vol. 11(4), pages 433-452, November.
    10. Si Shi & Yawen Jiang, 2022. "Does supplemental private health insurance incentivize household risky financial asset investment? Evidence from the China Household Financial Survey," International Journal of Health Economics and Management, Springer, vol. 22(4), pages 369-421, December.

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