Dynamic safety first expected utility model

Mei Choi CHIU, Hoi Ying WONG, Jing ZHAO

Research output: Contribution to journalArticle

Abstract

Levy and Levy (2009, The safety first expected utility model: Experimental evidence and economic implications, Journal of Banking and Finance 33, 1494–1506.) empirically show that a combination of safety first and expected utility (SFEU) principles play a key role in human decision-making process. This paper extends the SFEU model to the optimal dynamic investment in a continuous-time economy. We derive the analytic optimal trading strategy using the martingale approach. Interestingly, the optimal trading strategy replicates a portfolio of a vanilla call, a vanilla put, a digital put option, and a cash reserve. These derivatives therefore match the objective of SFEU investors, which offers an explanation to their popularity in the market. The model also implies that investors with more awareness of crash risk demand put options with lower strike price. Using option data of US major market indices and alternative proxies for market awareness of crash risk, we empirically test the model implications and find that market awareness of crash risk can explain the dynamics of index option open interest. Copyright © 2018 Elsevier B.V. All rights reserved.
Original languageEnglish
Pages (from-to)141-154
JournalEuropean Journal of Operational Research
Volume271
Issue number1
Early online dateMay 2018
DOIs
Publication statusPublished - Nov 2018

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Expected Utility
Crash
Safety
Trading Strategies
Optimal Strategy
Banking
Finance
Martingale
Model
Continuous Time
Decision making
Decision Making
Economics
Derivatives
Imply
Derivative
Market
Safety-first
Expected utility
Alternatives

Citation

Chiu, M. C., Wong, H. Y., & Zhao, J. (2018). Dynamic safety first expected utility model. European Journal of Operational Research, 271(1), 141-154. doi: 10.1016/j.ejor.2018.05.002

Keywords

  • Finance
  • Dynamic investment
  • Safety first
  • Expected utility
  • Martingale approach
  • Crash risk