Utility Functions whose Parameters depend on Initial Wealth

Conventional one‐period utility functions in Economics assume that initial wealth only enters preferences through the definition of final wealth. Consequently, those utility functions most utilized (i.e., exponential and quadratic) have implausible risk characteristics. The authors characterize a ne...

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Bibliographic Details
Published in:Bulletin of economic research 2003-10, Vol.55 (4), p.357-371
Main Authors: Pedersen, Christian S., Satchell, S. E.
Format: Article
Language:English
Subjects:
D81
Economic analysis
Economic theory
Economics
functions
G11
initial wealth
Preferences
Risk
Risk aversion
Risk theory
Studies
utility
Utility functions
Wealth
Welfare
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Summary:Conventional one‐period utility functions in Economics assume that initial wealth only enters preferences through the definition of final wealth. Consequently, those utility functions most utilized (i.e., exponential and quadratic) have implausible risk characteristics. The authors characterize a new class of utility function whose risk parameters depend upon initial wealth and obtain several desirable results. In particular, investors with quadratic and exponential utility functions can have decreasing risk aversion, and risky assets in a quadratic utility multi‐asset environment do not have to be inferior as implied by the traditional framework.
ISSN:0307-3378
1467-8586
DOI:10.1111/1467-8586.00181