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Dynamic Portfolio Allocation, the Dual Theory of Choice and Probability Distortion Functions

Published online by Cambridge University Press:  17 April 2015

Mahmoud Hamada ,
Michael Sherris  and
John van der Hoek
Mahmoud Hamada
Affiliation:
School of Finance and Economics, University of Technology of Sydney, Sydney, Australia, E-mail: [email protected]
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Abstract

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Standard optimal portfolio choice models assume that investors maximise 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 optimisation 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 allocationdual theoryprobability distortionequilibrium pricing
Type
Articles
Information
ASTIN Bulletin: The Journal of the IAA , Volume 36 , Issue 1 , May 2006 , pp. 187 - 217
Copyright
Copyright © ASTIN Bulletin 2006

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