26.03.2008 – Skewness Preference, Risk Taking and Expected Utility Maximization

March 26, 2008

26 March 2008Lille
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W. Henry Chiu –
School of Social Sciences,
University of Manchester, UK

Date and place: 26/03/2008 at 14:00
IÉSEG School of Management – 7 rue Solférino – 59000 LILLE
Lecture Room: E21

IÉSEG Seminar
jointly with LEM UMR8179

Paper and slides:
Download the paper (PDF – 350333 Ko)

Description: Available empirical evidence suggests that skewness preference plays an important role in understanding asset pricing and gambling. This paper establishes a skewness-comparability condition on probability distributions that is necessary and sufficient for any decision maker’s preferences over the distributions to depend on their means, variances and, third moments only. Under the condition, an Expected Utility maximizer’s preferences for a larger mean, a smaller variance, and a larger third moment are shown to parallel respectively his preferences for a first-degree stochastic dominant improvement, a mean-preserving contraction, and a downside risk decrease and are characterized in terms of the von Neumann-Morgenstern utility function in exactly the same way. The condition and its characterizations permit a rigorous evaluation of the available empirical evidence on skewness preference in the context of asset pricing and gambling. By showing that all Bernoulli distributions are mutually skewness comparable, we further show that in the wide range of economic models where these distributions are used individuals’ decisions under risk can be understood as tradeoffs between mean, variance, and skewness. Our results on skewness-inducing transformations of random variables can also be applied to analyze the effects of progressive tax reforms on the incentive to make risky investments.