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On the quality of Taylor approximations to expected utility

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  • Georgios Skoulakis

Abstract

This article presents evidence on the quality of Taylor series approximations to expected utility. To provide a transparent assessment in a broader setting, we assume that log portfolio returns follow a Gram--Charlier distribution that incorporates skewness and excess kurtosis and consider an investor with Constant Relative Risk Aversion (CRRA) preferences. In this framework, we obtain closed-form approximations to expected utility based on Taylor expansions with respect to gross and log portfolio return. We illustrate the quality of the two approximations across a wide range of scenarios in terms of distribution parameters and levels of risk aversion. The Taylor expansion with respect to log portfolio return is shown to produce reliable approximations.

Suggested Citation

  • Georgios Skoulakis, 2012. "On the quality of Taylor approximations to expected utility," Applied Financial Economics, Taylor & Francis Journals, vol. 22(11), pages 863-876, June.
    • Handle: RePEc:taf:apfiec:v:22:y:2012:i:11:p:863-876
    DOI: 10.1080/09603107.2011.628294
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    Cited by:

    1. Fahrenwaldt, Matthias A. & Sun, Chaofan, 2020. "Expected utility approximation and portfolio optimisation," Insurance: Mathematics and Economics, Elsevier, vol. 93(C), pages 301-314.

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