Dynamic portfolio allocation, the dual theory of choice and probability distortion functions
Date
2006
Authors
Hamada, Mahmoud
Sherris, Michael
van der Hoek, John
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Journal article
Citation
ASTIN Bulletin, 2006; 36(1): 187-217
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Mahmoud Hamada, Michael Sherris and John van der Hoek
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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.
School/Discipline
School of Mathematical Sciences : Applied Mathematics
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© 2006 by Astin Bulletin