Abstract
We add an independent unfair background risk to higher-order risk-taking models in the current literature and examine its interaction with the main risk under consideration. Parallel to the well-known concept of risk vulnerability, which is defined by Gollier and Pratt (Econometrica 64:1109–1123, 1996), an agent is said to have a type of higher-order risk vulnerability if adding an independent unfair background risk to wealth raises his level of this type of higher-order risk aversion. We derive necessary and sufficient conditions for all types of higher-order risk vulnerabilities and explain their behavioral implications. We find that as in the case of risk vulnerability, all familiar HARA utility functions have all types of higher-order risk vulnerabilities except for a type of third-order risk vulnerability corresponding to a downside risk aversion measure called the Schwarzian derivative.
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Notes
The concept of downside risk aversion is established by Menezes et al. (1980).
Liu and Meyer (2012) also contribute to this result.
Denuit and Eeckhoudt (2010a) define the nth-order Arrow–Pratt risk aversion measure as \(-u^{(n+1)}(x)/u^n(x)\).
Different background risks discussed in the literature include labor income risk, housing risk, entrepreneurial risk. See, for example, Campbell (2006) for a brief review of this literature.
The main technical reason is that in the cases of type 2 and type 3 DRVs, \(\tau _i(x)\) is a ratio of two linear functions of the derivatives of a utility function, thus characterizing DRV in these two cases is equivalent to solving a linear-fractional programming problem, while in the other three cases, it is not.
The verification is omitted for brevity but is available on request.
If a utility function exhibits nth-order strictly risk aversion for every n, it is said to have mixed risk aversion by Caballe and Pomansky (1996). They point out that most utility functions used in examples have mixed risk aversion.
Liu and Meyer’s (2013) Theorem 3 states that if u(x) has strictly greater (n / m)th-order risk aversion than v(x), then there exists \(\delta >0\), such that \(\int _{x-\delta }^{x+\delta }ud(F-G)/\int _{x-\delta }^{x+\delta } ud(F-H)>\int _{x-\delta }^{x+\delta }vd(F-G)/\int _{x-\delta }^{x+\delta }vd(F-H)\) for all F(y), G(y), and H(y) on \([x-\delta , x+\delta ]\) such that G(y) and H(y) have more nth and mth-degree risk than F(y), respectively.
According to Diamond and Stiglitz (1974), a change in risk \(F(x)\rightarrow G(x)\) on [a, b] is a mean-utility-preserving risk increase for a utility function u with wealth \(w_0\) if \(\int _a^yu^\prime (w_0+x)G(x)\mathrm{d}x\ge \int _a^bu^\prime (w_0+x)F(x)\mathrm{d}x\), \(\forall x\in [a, b]\), with the equality holding at \(y=b\).
See, for example, Theorem 3 in Diamond and Stiglitz (1974).
For brevity, in the rest of the proof, we omit the argument \((x+{\tilde{\epsilon }})\) of the functions under the expectation operator.
See, for example, Gollier and Pratt’s (1996) argument in the proof of their Proposition 2.
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Appendices
Appendix 1: Proof of Theorem 1
To prove the theorem, we need the following lemma. Let \(\varOmega _0\) be the set of all zero-mean binary random variables. Let \(\varOmega \) be any set of zero-mean random variables which contains \(\varOmega _0\). Let f(x), g(x), and h(x) be three functions such that \(\forall ~{\tilde{\epsilon }}\in \varOmega \), \(Ef({\tilde{\epsilon }})\ge 0\), \(Eg({\tilde{\epsilon }})\ge 0\), and \(Eh({\tilde{\epsilon }})\ge 0\).
Lemma 2
\(\forall ~{\tilde{\epsilon }}\in \varOmega \), \(Eg({\tilde{\epsilon }})Eh({\tilde{\epsilon }})\ge [Ef({\tilde{\epsilon }})]^2\) if and only if the inequality is true for all \({\tilde{\epsilon }}\in \varOmega _0\).
Proof We first prove the following statement: \(\forall ~{\tilde{\epsilon }}\in \varOmega \), \(Eg({\tilde{\epsilon }})Eh({\tilde{\epsilon }})\ge [Ef({\tilde{\epsilon }})]^2\), if and only if \(\forall ~{\tilde{\epsilon }}_1\in \varOmega \) and \(\forall ~{\tilde{\epsilon }}_2\in \varOmega \), \(Eg({\tilde{\epsilon }}_1) Eh({\tilde{\epsilon }}_2) + Eg({\tilde{\epsilon }}_2)Eh({\tilde{\epsilon }}_1)\ge 2Ef({\tilde{\epsilon }}_1) Ef({\tilde{\epsilon }}_2)\). This is proved as follows. To prove the “if” part, we let \({\tilde{\epsilon }}_1={\tilde{\epsilon }}_2\) in the latter inequality, while to prove the “only if” part, we need only note that
On the other hand, if we fix either of the two random variables, the expression \(Eg({\tilde{\epsilon }}_1) Eh({\tilde{\epsilon }}_2) + Eg({\tilde{\epsilon }}_2)Eh({\tilde{\epsilon }}_1)- 2Ef({\tilde{\epsilon }}_1) Ef({\tilde{\epsilon }}_2)\) is linear in the distribution of the other (in the probabilities of its possible values). This implies that \(\forall ~{\tilde{\epsilon }}_1\in \varOmega \) and \(\forall ~{\tilde{\epsilon }}_2\in \varOmega \), \(Eg({\tilde{\epsilon }}_1) Eh({\tilde{\epsilon }}_2) + Eg({\tilde{\epsilon }}_2)Eh({\tilde{\epsilon }}_1)\ge 2Ef({\tilde{\epsilon }}_1)Ef({\tilde{\epsilon }}_2)\) if and only if \(\forall ~{\tilde{\epsilon }}_1\in \varOmega _0\) and \(\forall ~{\tilde{\epsilon }}_2\in \varOmega _0\), the inequality is true. Now applying the preceding statement for the case where \(\varOmega =\varOmega _0\), we immediately obtain the lemma. \(\square \)
With the help of Lemma 2, we are now ready to prove the theorem. The result where \(i=2\) and 3 is a special case of Statement 1 of Theorem 5 which is proved in the last appendix; thus, we need only prove the result for the other three cases. Note that as an unfair risk can be decomposed into a certain reduction in wealth and a zero-mean risk, a necessary [sufficient] condition for all independent zero-mean background risks to increase \(\tau _i(x)\) combined with the condition that \(\tau _i(x)\) is monotone decreasing is a necessary [sufficient] condition for all independent unfair background risks to increase \(\tau _i(x)\). Thus, we need only prove the result for the case of zero-mean background risks.
To prove the result for \(\tau _1(x)=C(x)\), note that the inequality \({\hat{C}}(x)\ge C(x)\) is equivalent to
Thus, the problem is to characterize the utility function u(x) which satisfies the following condition
It is straightforward to see that Lemma 2 is applicable to this case. From this lemma, it is clear that the inequality \({\hat{C}}(x)\ge C(x)\) is true for all zero-mean risks if and only if it is true for all zero-mean binary risks, which is equivalent to Inequality (1) as \(C(x)=(\frac{1}{R(x)})^\prime \). This proves the result for \(\tau _1(x)\).
To prove the result for \(\tau _4(x)=-R^\prime (x)\), we have
Thus, the inequality \(-{\hat{R}}^\prime (x)\ge -R^\prime (x)\) is equivalent to
It follows that the problem is to characterize the utility function u(x) which satisfies the following condition
If for some zero-mean \({\tilde{\epsilon }}\), \(E[u^{\prime \prime \prime } (x+{\tilde{\epsilon }}) + R^\prime (x)u^{\prime }(x+{\tilde{\epsilon }})]<0\), then there must exist a zero-mean binary \({\tilde{\epsilon }}\) such that \(E[u^{\prime \prime \prime } (x+{\tilde{\epsilon }}) + R^\prime (x)u^{\prime }(x+{\tilde{\epsilon }})]<0\). Thus, we need only consider the case where for all zero-mean risks, \(E[u^{\prime \prime \prime } (x+{\tilde{\epsilon }}) + R^\prime (x)u^{\prime } (x+{\tilde{\epsilon }})]\ge 0\). Now Lemma 2 is applicable to this case, and the inequality \(-{\hat{R}}^\prime (x)\ge -R^\prime (x)\) is true for all zero-mean risks if and only if it is true for all binary zero-mean risks, which is equivalent to Inequality (4). This proves the result for \(\tau _4(x)\).
To prove the result for \(\tau _5(x)=S(x)\), we have
Thus, the inequality \({\hat{S}}(x)\ge S(x)\) is equivalent to
It follows that the problem is to characterize the utility function u(x) which satisfies the following condition
Similar to the case of \(\tau _4(x)\), we need only consider the case where for all zero-mean risks, \(E[u^{\prime \prime \prime }(x+{\tilde{\epsilon }}) - S(x)u^\prime (x+{\tilde{\epsilon }})]\ge 0\). Again, Lemma 2 is applicable to this case, and Inequality (14) is true for all zero-mean risks if and only if it is true for all binary zero-mean risks, which is equivalent to Inequality (5) as \(S(x)=-R^\prime (x)-0.5R^2(x)\). This proves the result for \(\tau _5(x)\). \(\square \)
Appendix 2: Proof of Theorem 2
As was explained at the beginning of the proof of Theorem 1, we need only prove the result for the case of zero-mean background risks. The result where \(i=1\) follows from Theorem 1 in Hara et al. (2011), and its proof can be found there. The result where \(i=2\) and 3 is a special case of Statement 2 of Theorem 5 which is proved in the last appendix; thus, we need only prove the result for the other two cases.
To prove the result where \(i=4\), we have \({\hat{R}}(x)=E(\frac{u^\prime }{Eu^\prime }R)\).Footnote 13 Differentiating the equation with respect to x, we obtain
As \(E(\frac{u^\prime }{Eu^\prime })^\prime =0\), we have \(E[(\frac{u^\prime }{Eu^\prime })^\prime R]=E[(\frac{u^\prime }{Eu^\prime })^\prime (R-{\hat{R}}(x))]\). Moreover, as \((\frac{u^\prime }{Eu^\prime })^\prime = \frac{u^\prime }{Eu^\prime }({\hat{R}}(x)-R)\), we obtain
This and Eq. (15) lead to
Adding \(R^\prime (x)Eu^\prime \) to both sides, we obtain
Meanwhile, we have \((Eu^\prime )^2 E(u^\prime ({\hat{R}}(x)-R)^2) = E[u^\prime (-Eu^{\prime \prime }-REu^\prime )^2] = E[u^\prime (R^\prime (x)u^\prime (x)\epsilon +O(\epsilon ^2))^2 ]=R^{\prime 2}(x)u^{\prime 3}(x)\sigma _\epsilon ^2 +O(\sigma _\epsilon ^3)\). This implies that
We also have
The last two equation, together with Eq. (18), imply that \((-{\hat{R}}^\prime (x)+R^\prime (x))Eu^\prime \) is equal to
Thus for arbitrarily small \(\sigma _\epsilon \), \(-{\hat{R}}^\prime (x)\ge -R^\prime (x)\) only if \(R^\prime (x)u^{\prime \prime \prime }(x)+2u^\prime (x)\) \( R^{\prime 2}(x)- (u^\prime (x) R^\prime (x))^{\prime \prime }\ge 0\), which is equivalent to \(-R^{\prime \prime \prime }(x)+2R(x)R^{\prime \prime }(x)+2R^{\prime 2}(x) \ge 0\).
To prove the result where \(i=5\), we have
where again for brevity, we have omitted the argument \((x+{\tilde{\epsilon }})\) of the functions under the expectation operators.
Hence, we obtain
In the meantime, from Eq. (16), we have \(-E[(\frac{u^\prime }{Eu^\prime })^\prime R]=E[\frac{u^\prime }{Eu^\prime }({\hat{R}}(x)-R)^2]\), while \(E(\frac{u^\prime }{Eu^\prime }R^2) - (E\frac{u^\prime }{Eu^\prime }R)^2 = E[\frac{u^\prime }{Eu^\prime }({\hat{R}}(x)-R)^2]\). Hence from the preceding equation, we have
Rewrite it as
As we have \(Eu^\prime = u^\prime (x)+u^{\prime \prime \prime }(x) \sigma _\epsilon ^2+O(\sigma _\epsilon ^3)\), \(E(u^\prime S)=u^\prime (x)S(x)+(u^\prime (x)S(x))^{\prime \prime }\) \(\sigma _\epsilon ^2+O(\sigma _\epsilon ^3)\), and Eq. (19), it follows that \(({\hat{S}}(x)-S(x))Eu^\prime \) is equal to
Thus for arbitrarily small \(\sigma _\epsilon \), \({\hat{S}}(x)\ge S(x)\), only if \(-S(x)u^{\prime \prime \prime }(x)+(u^\prime (x)S(x))^{\prime \prime }\) \(+3u^\prime (x) R^{\prime 2}(x)\ge 0\). As \(S(x)=-R^\prime (x)-0.5R^2(x)\), it can be rewritten as \(S(x)(u^\prime (x)R(x))^\prime - (u^\prime (x)R(x)S(x))^\prime + (u^\prime (x)S^\prime (x))^\prime +3u^\prime (x) (S(x)\) \(+0.5R^2(x))^2\ge 0\). Simplifying it, we obtain \(-2R(x)S^\prime (x)+S^{\prime \prime }(x)+3 (S(x)+0.5R^2(x))^2\ge 0\). \(\square \)
Appendix 3: Proof of Theorem 3
The result where \(i=2\) and 3 is a special case of Statement 1 of Theorem 5 which is proved in the last appendix; thus, we need only prove the result for the other three cases. As was explained at the beginning of the proof of Theorem 1 in 1, we need only prove the result for the case of zero-mean risks. We first prove the following lemma.
Lemma 3
For \(i\in \{1, 4, 5\}\), \(\tau _i(x)\) is increased by a zero-mean background risk \({\tilde{\epsilon }}\) if
where \(h_i(x)\) is defined in Theorem 3.
Proof The results where \(i=4\) and 5 immediately follow from Eqs. (17) and (20), respectively; thus, we need only prove the case where \(i=1\). To prove this case, we have
Some simple calculations lead to
Meanwhile, from the Cauchy–Schwarz inequality (\( E{\tilde{\epsilon }}_1^2 E{\tilde{\epsilon }}_2^2 \ge [E({\tilde{\epsilon }}_1{\tilde{\epsilon }}_2)]^2\)), we have
Rewrite it as
This, together with Eq. (22), implies that
Hence, \({\hat{C}}(x)\ge C(x)\) if \( E[C(x+{\tilde{\epsilon }})h_1(x+{\tilde{\epsilon }}) ]\ge C(x)Eh_1(x+{\tilde{\epsilon }})\), where \(h_1(x)=\frac{(u^{\prime \prime }(x))^2}{u^\prime (x)}\). \(\square \)
We now use the lemma to prove the theorem. Applying the lemma, we need only prove that the inequality in Theorem 3 is necessary and sufficient for Inequality (21). This is shown as follows. It is well known that Inequality (21) is true for all zero-mean \({\tilde{\epsilon }}\) if and only if it is true for all zero-mean binary \({\tilde{\epsilon }}\), i.e., \(p\tau _i(x+\epsilon _1)h_i(x+\epsilon _1)+(1-p) \tau _i(x+\epsilon _2) h_i(x+\epsilon _2)\ge \tau _i(x)[ph_i(x+\epsilon _1) + (1-p)h_i(x+\epsilon _2)]\), for all \(p\in (0,1)\), \(\epsilon _1\) and \(\epsilon _2\) satisfying \(p\epsilon _1+(1-p)\epsilon _2=0\). After the elimination of p, this is equivalent to the condition that there exists a scalar m(x) such that
for any \(\epsilon _1>0>\epsilon _2\). By symmetry, the only candidate for m(x) is \(h_i(x)\tau _i^\prime (x)\). The above condition is thus equivalent to \(h_i(y)(\tau _i(y)-\tau _i(x))- h_i(x)\tau _i^\prime (x)(y-x)\ge 0\). \(\square \)
Appendix 4: Proof of Theorem 4
As was explained at the beginning of the proof of Theorem 1 in 1, we need only prove the result for the case of zero-mean risks. We first prove the following lemma. The proof uses a technique that is very close to the one used by Gollier and Pratt (1996) in the proof of their Proposition 3.
Lemma 4
Assume that for a given w, \(g(w)> 0\), and for all x, \(f(x)>0\), \(f^\prime (x)\le 0\), and \((\frac{g(x)}{f(x)})^\prime \le 0\). If for all x, \((\frac{g(x)}{f(x)})^{\prime \prime }\ge -(\frac{g(x)}{f(x)})^\prime \frac{f^\prime (x)}{f(x)}\) then, for any unfair \({\tilde{\epsilon }}, ~\frac{Eg(w+{\tilde{\epsilon }})}{Ef(w+{\tilde{\epsilon }})}\ge \frac{g(w)}{f(w)}\).
Proof Note that as for all x, \(f(x)>0\) and \((\frac{g(x)}{f(x)})^{\prime \prime }\ge -(\frac{g(x)}{f(x)})^\prime \frac{f^\prime (x)}{f(x)}\), we have \([(\frac{g(x)}{f(x)})^\prime f(x)]^\prime =(\frac{g(x)}{f(x)})^{\prime \prime } f(x)+ (\frac{g(x)}{f(x)})^\prime f^\prime (x)\ge 0\); i.e., \((\frac{g(x)}{f(x)})^\prime f(x)=g^\prime (x)-\frac{g(x)f^\prime (x)}{f(x)}\) is increasing. Thus as \(g(w)> 0\) and for all x, \(f^\prime (x)\le 0\), \(\frac{g(x)}{f(x)}\) is decreasing, and \(g^\prime (x)-\frac{g(x)f^\prime (x)}{f(x)}\) is increasing, y has the same sign as
which is equal to
Therefore, since the direction of integration cancels out the sign, we have
Since this is true for any \(\epsilon \), taking the expectation over a random variable \({\tilde{\epsilon }}\) yields
As f(w) and g(w) are both strictly positive and \(\frac{g(w)}{f(w)}\) is decreasing, the right-hand side is nonnegative, and it follows that \(\frac{Eg(w+{\tilde{\epsilon }})}{Ef(w+{\tilde{\epsilon }})}\ge \frac{g(w)}{f(w)}\). \(\square \)
We now use the lemma to prove Theorem 4. Let \(f(x)=h_i(x)\) and \(g(x)= (\tau _i(x)+\alpha _0)h_i(x)\), where \(h_i(x)\) is defined in Theorem 3 and \(\alpha _0>0\) is arbitrarily large. Note that for \(i=1, \ldots , 5\), for all x, \(f(x)=h_i(x)> 0\), and for any given w, as \(\alpha _0>0\) is arbitrarily large, \(g(w)=(\tau _i(w)+\alpha _0)h_i(w)>0\). Also note that for \(i=1\), \(C(x)\ge -0.5\) implies \(h_1^\prime (x)=-h_1(x)R(x)(2C(x)+1)\le 0\), for \(i=3\), \(h_i^\prime (x)=-u^{\prime \prime \prime }(x)\le 0\), and for \(i=2,~4,~5\), \(h_i^\prime (x)=u^{\prime \prime }(x)\le 0\). Moreover, as \(\tau _i(x)\) is decreasing, \(\frac{g(x)}{f(x)}=\tau _i(x)+\alpha _0\) is also decreasing. Furthermore, we have \(-(\ln h_i(x))^\prime =\zeta _i(x)\), where \(\zeta _i(x)\) is defined in the theorem, and it follows from the given condition in the theorem that \((\frac{g(x)}{f(x)})^{\prime \prime } +(\frac{g(x)}{f(x)})^\prime \frac{f^\prime (x)}{f(x)}= \tau _i^{\prime \prime }(x)-\tau _i^\prime (x)\zeta _i(x)\ge 0\). Thus, f(x) and g(x) satisfy all the conditions in the lemma. Now applying the lemma, we obtain \(\frac{Eg(w+{\tilde{\epsilon }})}{Ef(w+{\tilde{\epsilon }})}\ge \frac{g(w)}{f(w)}~\forall {\tilde{\epsilon }}\). This implies that \(\forall {\tilde{\epsilon }}, ~\frac{E[(\tau _i(w+{\tilde{\epsilon }}) + \alpha _0) h_i(w+{\tilde{\epsilon }})]}{Eh_i(w+{\tilde{\epsilon }})}\ge \frac{(\tau _i(w)+\alpha _0)h_i(w)}{h_i(w)}\), i.e., \(E[\tau _i(w+{\tilde{\epsilon }})h_i(w+{\tilde{\epsilon }})]\ge \tau _i(w)Eh_i(w+{\tilde{\epsilon }})\). Applying Lemma 3 of the last appendix, we immediately obtain the conclusion in the theorem. \(\square \)
Appendix 5: Proof of Theorem 5
As was explained at the beginning of the proof of Theorem 1 in 1, we need only prove the result for the case of zero-mean risks. We first prove Statement 1. The inequality \((-1)^{n-m}\frac{Eu^{(n)}(x+{\tilde{\epsilon }})}{Eu^{(m)}(x+{\tilde{\epsilon }})}\ge R_{n/m}(x)\) is equivalent to
It is well known that the above inequality is true for all zero-mean \({\tilde{\epsilon }}\) if and only if it is true for all zero-mean binary \({\tilde{\epsilon }}\).Footnote 14 Thus, the inequality is true for all zero-mean \({\tilde{\epsilon }}\) if and only if for all \(x_2< x< x_1\),
This is equivalent to the condition that there exists a scaler \(\kappa (x)\) such that
The only candidate for \(\kappa (x)\) is \(u^{(m)}(x)R_{n/m}^\prime (x)\), and it follows that the above condition is equivalent to \((-1)^{m-1}\xi (w, x)\ge 0\), where \(\xi (w, x)=u^{(m)}(x)(R_{n/m}(x)-R_{n/m}(w))- u^{(m)}(w)R_{n/m}^\prime (w)(x-w)\). This proves the first statement.
To prove the second statement, observe that \(\xi (w, w)=0\) and
which implies \(\frac{\partial \xi (w, x)}{\partial x}|_{x=w}=0\). It follows that to have \((-1)^{m-1}\xi (w, x)\ge 0\) \(\forall w, x\), it is necessary that \((-1)^{m-1}\frac{\partial ^2\xi (w, x)}{\partial x^2}|_{x=w}\ge 0\) \(\forall w\), which is equivalent to \(R_{n/m}^{\prime \prime }(w)\ge 2R_{(m+1)/m}(w)R_{n/m}^\prime (w)\) \(\forall w\).
To prove the third statement, let \(f(x)=(-1)^{m-1}u^{(m)}(x)\) and \(g(x)=(-1)^{n-1}u^{(n)}(x)\). Applying Lemma 4 in the last appendix, we immediately conclude that the third statement is true.
The proof of the fourth statement follows from the proof of Proposition 1 in Kimball (1993) and from the fact that \(R_{(n+1)/n}\) is isomorphic to risk aversion as applied to \((-1)^{n-1}u^{(n-1)}\). \(\square \)
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Huang, J., Stapleton, R. Higher-order risk vulnerability. Econ Theory 63, 387–406 (2017). https://doi.org/10.1007/s00199-015-0935-2
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DOI: https://doi.org/10.1007/s00199-015-0935-2