Abstract
Standard optimal portfolio choice models assume that investors maximize the expected utility of their future outcomes. However, behaviour which is inconsistent with the expected utility theory has often been observed.
In a discrete time setting, we provide a formal treatment of risk measures based on distortion functions that are consistent with Yaari's dual (non-expected utility) theory of choice (1987), and set out a general layout for portfolio optimization in this non-expected utility framework using the risk neutral computational approach.
As an application, we consider two particular risk measures. The first one is based on the PH-transform and treats the upside and downside of the risk differently. The second one, introduced by Wang (2000) uses a probability distortion operator based on the cumulative normal distribution function. Both risk measures rank-order prospects and apply a distortion function to the entire vector of probabilities.
KEYWORDS: Portfolio allocation, dual theory, probability distortion, equilibrium pricing
In a discrete time setting, we provide a formal treatment of risk measures based on distortion functions that are consistent with Yaari's dual (non-expected utility) theory of choice (1987), and set out a general layout for portfolio optimization in this non-expected utility framework using the risk neutral computational approach.
As an application, we consider two particular risk measures. The first one is based on the PH-transform and treats the upside and downside of the risk differently. The second one, introduced by Wang (2000) uses a probability distortion operator based on the cumulative normal distribution function. Both risk measures rank-order prospects and apply a distortion function to the entire vector of probabilities.
KEYWORDS: Portfolio allocation, dual theory, probability distortion, equilibrium pricing
Volume
Vol. 36, No. 1
Page
187-217
Year
2006
Publications
ASTIN Bulletin
