Arrow-Pratt risk aversion, risk premium and decision weights

Haim Levy*, Moshe Levy

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

26 Scopus citations

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 languageAmerican English
Pages (from-to)265-290
Number of pages26
JournalJournal of Risk and Uncertainty
Volume25
Issue number3
DOIs
StatePublished - 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

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