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 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.
| Original language | English |
|---|---|
| Pages (from-to) | 265-290 |
| Number of pages | 26 |
| Journal | Journal of Risk and Uncertainty |
| Volume | 25 |
| Issue number | 3 |
| DOIs | |
| State | Published - 2002 |
Bibliographical note
Funding Information:The Authors acknowledge the helpful comments of the anonymous referee, and Kip Viscusi, the editor. This study was financially supported by the Krueger Center of Finance and by the Zagagi Fund.
Keywords
- Decision-weights
- Risk aversion
- Risk premium
- Stochastic dominance