Aversion to Risk and Downside Risk in the Large and in the Small under Non-Expected Utility: A Quantile Approach

  • Chavas J
  • Kim K
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Abstract

This paper proposes a decomposition of the cost of risk (as measured by a risk premium) across intervals/quantiles of the payoff distribution. The analysis is based on general smooth risk preferences. While this includes the expected utility model as a special case, the investigation is done under a broad class of non-expected utility models. We decompose the risk premium into additive components across quantiles. Defining downside risk as the risk associated with a lower quantile, this provides a basis to evaluate the cost of exposure to downside risk. We derive a local measure of the cost of risk associated with each quantile. It establishes linkages between the cost of risk, risk preferences and the distribution of risky prospects across quantiles (as measured by quantile variance and skewness). The analysis gives new and useful information on how risk aversion, exposure to downside risk and departures from the expected utility model interact as they affect the risk premium.

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Chavas, J.-P., & Kim, K. (2015). Aversion to Risk and Downside Risk in the Large and in the Small under Non-Expected Utility: A Quantile Approach. Theoretical Economics Letters, 05(06), 784–804. https://doi.org/10.4236/tel.2015.56090

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