Decreasing Risk Aversion and Mean-Variance Analysis Author(s): Larry G. Epstein Source: Econometrica, Vol. 53, No. 4 (Jul.

, 1985), pp. 945-961 Published by: The Econometric Society Stable URL: http://www.jstor.org/stable/1912662 Accessed: 03/11/2008 15:24
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Econometrica, Vol. 53, No. 4 (July, 1985)

DECREASING RISK AVERSION AND MEAN-VARIANCE ANALYSIS

BY LARRY G. EPSTEINI
This paper formulates a set of decreasing-absolute-risk-aversion postulates and shows that only mean-variance utility functionals can satisfy them. These postulates are used to axiomatize specific classes of mean-variance functionals. Finally, an equivalence is established between these postulates and corresponding comparative statics properties of asset demands in two-asset portfolio problems.

1. INTRODUCTION

THIS PAPERCONSIDERStwo common hypotheses in the literature on choice under

uncertainty: (i) individuals exhibit declining absolute risk aversion (DARA), and (ii) the ranking of alternative distributions depends only on their means and variances. The central result of the paper is that, under suitable regularity conditions, the latter hypothesis is implied by an appropriate formulation of DARA. That is, mean-variance utility functions are the only ones which satisfy the notions of DARA described below. Mean-variance analysis is particularly important in finance and largely because of the central role played by the capital asset pricing model in financial theory. A mean-variance framework is justified if the class of distributions is suitably restricted [2]; for example, if they are all normal. The capital asset pricing model is also justified in a continuous time model where uncertainty is generated by diffusion processes. (See [9].) But more generally the specification of meanvariance utility functions is an ad hoc functional form specification that is adopted for reasons of tractability. This paper provides a new justification for meanvariance analysis; namely, the basic DARA postulate. The most commonly used formulation of DARA is due to Arrow [1] and Pratt [10]. Their hypothesis is adopted in numerous papers in order to generate qualitative comparative statics results. Recently, Ross [11] and Machina [7] have strengthened the Arrow-Pratt hypothesis in order to increase its predictive content. Alternative formulations of DARA, some of which strengthen existing hypotheses, are investigated in this paper. They permit qualitative comparative statics results to be derived in situations where earlier hypotheses have no predictive power. Suppose (x-,yj,J) is a trivariate distribution such that the conditional means E[j/x] and E[e/y] vanish for all x and y.2 X-+ e and y + e define mean preserving
l Mark Machina provided useful comments and an important proof. I have also benefited from discussions with Stuart Turnbull and from the comments of participants at the "Brown Bag" Theory Workshop at the University of Toronto, a co-editor, and two referees. 2 The notation adopted is consistent with that in [7]. Thus x denotes a random variable while x is a constant. The equation x = x indicates that the random variable x is constant at the level given by x. Fj,g, FX,Zdenote the cumulative distribution functions of i + e and (x, z) respectively; G, and Gc,d denote the distributions which assign unit probability to the points c, and (c, d) respectively. All integrals are over [0, M]. For a cumulative density function F, yt(F) and u2(F) denote its mean and variance respectively. The terms increasing and decreasing when applied to a function, are intended in the weak sense.

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spreads [12] of x and y respectively. Think of e as defining the "same" additive gamble for either base wealth x or -. Let vr be a constant such that the decision and define v; similarly. Then maker is indifferent between x- and x-+ e + r existing hypotheses may be described as follows:3 = x, -y= y, y > x. DARA1 (Arrow-Pratt):vr - v.yifZx DARA2 (Ross): ir ; if; =x+w, w-O. ; ifjy = x +w, w

DARA3 (Machina): vr

In the Arrow-Pratt hypothesis the two base wealths are nonstochastic. Thus their hypothesis is too weak to have relevance to a real world setting where not all risks are insurable. With this motivation Ross permits the base wealth xZ to be random, but he maintains that the increment w is nonstochastic. Machina argues that this restriction is unrealistic and deletes it in his formulation. He requires only that the two base wealth distributions are comparable according to the criterion of first degree stochastic dominance. Restrict distributions to lie in D[O, M], the set of all cumulative distribution Let R be a subset of D2[0, M] = functions over [0, M], where M <0. D[O, M] x D[O, M]. The above hypotheses are special cases of the following: R-DARA: vi >, vr if (Fx, Fy) E R. In DARAI-3 particular specifications for R are adopted. In this paper alternative restrictions for R are considered. In all cases, it is shown that R-DARA implies mean-variance utility. Three specifications in particular, it is argued, lead to intuitively plausible-hypotheses. These specifications provide complete characterizations of appropriate subclasses of mean-variance utility functions. The paper proceeds as follows: Section 2 describes the weakest form of DARA considered in this paper. Its relationship with mean variance analysis is established in Section 3. Three stronger hypotheses are considered in Section 4. Section 5 establishes the equivalence, under suitable regularity conditions, of some special cases of R-DARA and corresponding comparative statics properties of asset demands in two asset portfolio problems. Proofs are gathered in the Appendix. Some are adaptations of arguments from [7] to which the reader is referred for more detail. The extended discussion in [7] of motivation and related research and much of the intuition supplied there are also relevant to the present analysis.

3Usually the risk premium v,j is defined by indifference between x + e and x - v,j. The difference between v,j and 7rj is analogous to the difference between equivalent and compensating variations of a price change in demand theory. For each of DARA1-DARA3 replacing 7rj by v,j leads to an equivalent hypothesis. But the distinction between the two premia is significant for the hypotheses investigated in this paper as shown below.

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An individual is assumed to rank elements of D[O, M] by means of a preference functional V. Most frequently in the literature on choice under uncertainty an expected utility specification is adopted for V But Machina [7] has shown that the expected utility hypothesis is inconsistent with DARA3, unless there is risk neutrality. It is similarly inconsistent with the R-DARA hypotheses considered here. Thus follow [6,7] and maintain only that V is differentiable. To be precise, view D[O, M] as a topological subspace of L'[0, M], the space of absolutely integrable functions on [0, M] with the L' norm; and assume that V is once Frechet differentiable. In [6] it was shown that there exists at each Fo in D[O, M] a "local utility function" U(; FO), defined on [0, M], such that for any F in D[O, M], (1) V(F)-V(Fo)=j| U(w; Fo)[dF(w)-dFo(w)] + o(IIF - FoII)1

Here o(*) denotes a function of higher order than its argument and L' norm. The following preliminary assumption is adopted.

Iis the

ASSUMPTION 1: V is Frechet differentiable and the local utility function U is such that U1(x; F) and U11(x; F) exist and are continuous in x for each F in 1(x; F) - 0 everywhere. D[O, M]. Moreover, U1(x; F) > 0 and U1

U1> 0 guarantees that V is monotonic in the sense of first degree stochastic dominance. The nonpositive second order derivative is equivalent to risk aversion in the sense that V is averse to all mean preserving increases in risk. (See [6].) The R-DARA postulates considered in this paper are those for which the set R satisfies both of the following conditions: R. 1: If (Fe, Fj-) (=R, y, y*E [0, M], then there exists p, 0< j < 1, such that ((1-p)F +pG,, (1-p)Fj*+pGy*)G R for all O<p<pj. R.2: For each F in D[O, M], (F, F) E R, the closure of R in D2[0, M], where the latter has the product topology. Condition R.2 is less contentious; in particular, note that it is satisfied by each of the postulates DARAI-DARA3. Thus it is R. 1 which is primarily responsible for the strong results below. Note that R.1 is weaker than the requirement that R be an open subset of D2[0, M], where the latter has the product topology. Thus at first glance it might appear to be a purely technical and possibly innocuous assumption. But that is not the case. In particular, R. 1 is violated by the R's that correspond to each of DARA1-3. Some insight into the content of R. 1 may be provided by the following simple example: Let there be 4 states of the world with the corresponding probability vector ((1 -p)/2, (1 -p)/2, p12, p12), where p is a small positive number.

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Represent random variables by 4-dimensional vectors whose components represent realizations in the various states of the world. Let z = (z, z, z, z) and
z* = (z*, z*, z*, z*) be two nonstochastic distributions with z < z*. Suppose that

(Fe, F;*) E R. (That is the case for each of the sets R corresponding to DARA1-3.) Let x=(z, z, y, y) and x*=(z*, z*, y*, y*). Then Fz=(1-p)F +pGy, F,z*= (1 -p)F1*+pGy*, and R.1 implies that (Fl, F,z*)G R for small p, and therefore that ITi ? ITZ*. Moreover, this inequality is valid for all additive gambles e and for all values of y and y*. In particular, it must be true if y > y* and if e = (0, 0, 1, -1). Thus vz - vz* even for a gamble e that is nontrivial only in states of the world (3 and 4) where x- is larger than x*! In spite of the fact that those states occur with low probability, this implication appears counterintuitive, at least given the intuition provided by the Arrow-Pratt DARA postulate and the independence axiom. In contrast, vz - vz* is not implied by Machina's DARA3, for example, because Fz* first order stochastically dominates FZ only if y S y*. The example shows clearly that R.1 is potentially acceptable only if the independence axiom of expected utility theory is dropped; in particular, only if it is accepted that an individual's aversion to gambles that are confined to a specific subset of states of the world can be influenced by the entire base distribution of wealth. Though the independence axiom is intuitively appealing and has been dominant for several decades in the theory of choice under uncertainty, it is no longer universally adopted. Machina [4] surveys the empirical and theoretical arguments against the independence axiom and surveys several nonexpected utility models of choice, including his own corresponding to (1) above.4 Moreover, as noted earlier, the independence axiom must be abandoned even if the more straightforward DARA3 postulate is adopted. Thus interest in R.1 cannot be ruled out on the basis of the above intuition. Further justification for the general requirement R.1 is not attempted directly. Rather, Section 4 presents three examples of R-DARA postulates which are readily interpreted and which have some intuitive plausibility. These examples serve to establish that the analysis below is mathematically nonvacuous and economically relevant. Since Theorem 1 below may be more easily appreciated by the reader if he has a concrete example in mind, an example is presented here. It may be motivated by first considering DARA1-DARA3. The latter suggest numerous other formulations. For example, DARA3 could be strengthened by requiring that g?Z whenever dominates x by second order stochastic dominance. A common feature of all these formulations is that y is preferable or indifferent to x. Thus the following hypothesis would appear to merit particular attention:5 DARA4: vz - v; if V(Fx ) - V(F, ). Clearly DARA4 is stronger than DARA3. It is also a special case of the general R-DARA hypothesis where R. 1 and R.2 are satisfied. To see this let R =
4 The theoretical arguments include temporal risks [5] and group risk sharing [8]. S Willig [13] considers a weaker hypothesis, that is similar in spirit, in an expected utility framework.

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{(F, G) E D2[0, M]: V(F) < V(G)}, and note that the Frechet differentiability of V (Assumption 1) implies that V is continuous and hence, in particular, that R is open.
3. MEAN VARIANCE UTILITY

In this section it is shown that the R-DARA hypothesis, where R satisfies conditions R. 1 and R.2, implies that utility can depend only on mean and variance. But another preliminary assumption is required. It concerns the following functional: (2) A(y; F)--U11I(Y; F)/ U,(w; F) dF(w),

y e [0, M], Fe D[O, M].

ASSUMPTION 2: A(y;

) is continuous on D[O, M] for each ye [0, M].

A(y; F) resembles an Arrow-Pratt risk aversion measure which admits the well-known interpretation as twice the risk premium per unit of variance for a small gamble. Note that A(y; Gy)= - Ul(y; GY)/Ul(y; Gy), which reduces to the Arrow-Pratt index if the local utility function U is independent of the base distribution. A comparable interpretation may be provided for A(y; F) in the general case of a nonexpected utility functional. To see this, proceed informally. For small p > 0 and e > 0, and fixed z and y, let ff = 7r(e,p) be the unique solution to (3) V[(1-p)Fr+ +2GY+??+g+2 Gy-1+j,
= =V[(l-p)Fj+pGy].

Differentiate6 totally with respect to p and evaluate at p = 0 to derive

-(e,

0) =[ U(y +,l;

FF) + U( y-1e;
{

FF)

-U(y; Fj)]

U(w; F) dF(w).

(y; F2)/2. Thus ir(e, p) can For small e, the numerator is approximately e - U11 be approximated by ir(e, O)+p* aw(e, O)/1p, or by ep* A(y; F5)/2. In short,
IT-ep

*A(y; Fj)/2.

Finally, note that (3) has the form (3') V(F+j+v) =V(FR),

6 To differentiate, make use of (1), i.e., that locally V is approximately an expected utility functional. See [6].

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where E[e/x] = 0 identically, and 2(g)= ep. Thus A(y; F,) is approximated by e 2 iri/r-2()e which provides the desired interpretation. Theorem 1 is the central result of this section.
THEOREM 1: Let V satisfy Assumptions 1 and 2. Suppose that V satisfies R-DARA where R satisfies R.1 and R.2. Then the functional A satisfies

(4)

A(y; F),A(y*;

G)

Vy, y*E[O, M] and V(F, G)e R.

In addition, V can be expressed in the form7 (5) V(F)

=

v(,u(F), o"2(F)), o2(F)): F E D[O, M]},

for some differentiable function v with domain S --{(,(F),

wherev,>O,
(6)

V2 _f0;

and

A(y; F) = -2v2(A (F), &2(F))/ v1(,u(F), -2(F)).

Consider first the conclusions of the Theorem. The central conclusion is (5) that V is a mean-variance utility function. This is proven by first establishing the implication (4) of R-DARA. From (4) it follows that the risk aversion measure A is in fact independent of its first argument. But that implies (because of (2)) that the local utility function U( ; F) is quadratic for each F. The mean-variance specification then follows.8 Of course, (6) relates the risk aversion measure A(y; F) to the slope of the , _- - indifference curve, which is the standard measure in mean-variance analysis. The key to the proof of the Theorem is the proof of (4) and an informal and intuitive sketch of the latter may be provided: Let (Fe, Fj*) E R and y, y* G[0, M]. Define iT by (3). It was pointed out above that ir= 1Ti, where Fz is defined implicitly by (3) and (3'). Define iT* = iTR* and FR*by a similar set of equations where and y are replaced by z* and y* respectively. Then for small p, (Fi, Fx*) E R because of R. 1. Thus w7 R 1T* because of R-DARA. Finally, (4) follows from the risk premium interpretation provided above for the functional A(*, ). Given (4), R.2 and the continuity of A (Assumption 2) imply that A(y;F)>A(y*;F) VFeD[0,M].

Since y and y* are arbitraryA( ; F) must be constant, i.e., U1(, ; F) is constant, which implies the mean variance specification. The fact that the local utility function U is quadratic in its first argument has two interesting implications. First, U1( *; F) and U1I( *; F) S 0 can be satisfied for all y in [0, oo] only if U1 1 vanishes identically, in which case V is risk neutral. Thus the DARA hypothesis in the Theorem, monotonicity and strict risk aversion on D[O, M] for all M > 0, are inconsistent. But these properties are consistent if distributions are restricted to have supports lying in a given compact set [0, M], which restriction is imposed in this paper.
7Throughout the paper, equality between utility functionals is to be interpreted modulo ordinal equivalence. 8 I am indebted to Mark Machina for providing me with a proof of this step.

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Secondly, recall that in the expected utility framework quadratic utility indices are often criticized because they imply that the Arrow-Pratt measure is increasing in violation of DARAI. In terms of U above, this observation takes the form that - U I(y; F)! U1(y; F) is increasing in y if U1 1 does not vanish. But in the more general Machina framework where local utility functions may depend on F, the above noted property of the Arrow-Pratt measure is not relevant to risk-taking behavior. (See also [6; p. 300].) Thus not only does quadratic local utility not violate DARAI, it is necessary and, if suitably restricted, also sufficient for the much stronger hypotheses described in the next section. In the introduction it was noted that except for the trivial case of risk neutrality, expected utility theory is inconsistent with the new DARA postulates considered in this paper. In fact, to prove this inconsistency it is necessary to add a mild requirement for the set R. (Otherwise, a counterexample is provided by the expected utility functional V corresponding to a quadratic utility index. It exhibits R-DARA, where R = {(F, G) E D2[0, M]: ,u(F)> ,u(G)} satisfies R.1 and R.2; and on a suitable domain, V is monotonic and risk averse.) R.3: There exists (Fo, F,) E R such that Fo(x) > F, (x) for all x E (0, M). The condition imposed on Fo and F, is stronger than requiring that they be comparable by strict first degree stochastic dominance. (The latter would require Fo(x) - F, (x) for all x E [0, M] with strict inequality for at least one x.) But R.3 is satisfied by the specializations of R-DARA considered in the paper. Now the inconsistency may be proven as follows: If V is an expected utility functional, its local utility function U is independent of the base distribution. Thus write U(y; F) = u(y). Condition (4) implies that
J

u'(w)[dG(w) - dF(w)] >- O V(F, G) E R.

But take (F, G) = (FogF1). Since u' is decreasing, the above integral is nonpositive and equals zero only if u' is constant. Thus R-DARA, with R.1, R.2 and R.3, implies risk neutrality if V is an expected utility functional. It is evident that condition R.1 does not necessarily, at this level of generality, reflect any form of decreasing risk aversion. Indeed, it is shown in the next section that preferences which everyone would agree to call increasingly risk averse also satisfy R-DARA with R.1 and R.2. The quadratic expected utility functional described prior to the statement of R.3 provides another such example. The restrictions imposed by the R-DARA hypotheses are twofold: (a) for all (F, G) in the set R the relative magnitudes of the risk premia for the base distributions F and G are independent of the gamble e, and (b) R is "large" because of R.1 and the closure condition R.2. These are the properties which imply mean-variance utility. Thus Theorem 1 could be loosely interpreted as proving that "systematically changing risk aversion" implies mean-variance utility. But since hypotheses about the systematic variation in (absolute) risk aversion in practice are usually DARA postulates, the interpretation described in the introduction and title to this paper has been adopted.

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PARTICULAR

HYPOTHESES

4.1. Constant Risk Aversion For a first example consider a strong form of constant (absolute) risk aversion. Suppose that risk premia are independent of base wealth; then for a given gamble e, rj= iy for all distributions Fi and Fy. Then the set R is all of D[O, M] x D[O, M] and the hypotheses R. 1 and R.2 are trivially satisfied. Theorem 1 shows that if V exhibits constant risk aversion in this sense then V is a mean-variance utility function having straight line and parallel indifference curves, i.e., for all F

(7)

o2(F)), V(F) = v(,uL(F),

where

VQ(1,o-2) =

- ao-2,

a -O.

In fact, Theorem 2 provides a complete characterization of this common functional form specification. 2: Let V satisfy Assumptions 1 and 2. Then the following statements THEOREM are equivalent: (a) V satisfies R-DARA where R = D[O, M] x D[O, M]. (b) V has the functional form in (7). The expression "constant absolute risk aversion" immediately evokes the expected utility functional with an exponential von Neumann-Morgenstern utility index. For this specification risk premia are invariant to the base distribution F, but only for gambles J that are distributed independently of i. For the functional forms in (7) the constancy of risk premia applies for the much larger class of gambles with zero conditional means, which class corresponds to the set of mean preserving increases in risk [12]. (Machina [7; footnote 4] has emphasized the restrictiveness of the assumption of an independently distributed gamble e.) 4.2. Risk Aversion and the Level of Utility A natural weakening of the hypothesis of constant absolute risk aversion is provided by DARA4, defined in Section 3. Since Theorem 1 is applicable, only mean-variance utility functions are consistent with DARA4. In fact the class of utility functionals that satisfy DARA4 can be completely characterized.
THEOREM 3: Let V satisfy Assumptions 1 and 2. Then thefollowing statements are equivalent: (a) V satisfies DARA4. (b) V has the mean-variance functional

form (5) where -

V2(0, u2)/VI(b,

u2) = k(v(,V (

2))

for all (g,

0.2)

in the domain

of v and for some continuous, decreasing, and non-negative function q defined on the range of V. The indifference map of the typical mean-variance utility function corresponding to DARA4 is shown in Figure 1. ,u- (r2 indifference curves are straight lines but not necessarily parallel. Higher indifference curves have smaller slopes. The intersection point of these curves lies outside the domain where the utility functional V is well-behaved.

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domain of v

~~~~~~~~~~,J2
FIGURE 1-Mean-varianceindifference

map for DARA4 utility functional.

Utility functions consistent with Figure 1 may be constructed analytically as follows: Let 4)be a differentiable decreasing function with domain (- 00, oo) and range lying in (8, M-1) for some 8 > 0. Let K > 0 be a constant and suppose that d (l/4(z))/dz < KM-" for zE ( -oo, c). Let
2

(8)

D(z, ,u,o ) =-

4)(z)

fZK,
2

for z E (- oo, oo) and (,u,o.2) E {(A(F), u2(F)): F E D[O, M]}. Then D is continuous and strictly decreasing in z and limz,(0 D(z; g, o-2) = 00) limz _.o D(z; A, a.2) = 00. Thus the equation D(z; ,u, o-2) = 0 has a unique solution z. Define v(,u, .2) to be that unique solution; that is, v(,t, 0.2) is defined implicitly by (9) D(v(,
2,0)
) =

0.

Total differentiation of (9) yields immediately that - v2/v1 = +(v) and thus Figure 1 and DARA4 are valid. In the special case where 4 is a constant function, (8) and (9) reduce to the constant absolute risk aversion specification (7). Next consider two hypotheses which are variants of DARA4. First, refer to the alternative risk premium definition mentioned in footnote 3. That is, suppose
VX is the constant

such that x-+

and x

- Pz

are indifferent. The following

alternative to DARA4 seems worthy of consideration:

DARA4':
v;-

P vy whenever V(Fj) S V(F;).

DARA4' also implies mean-variance utility, but it is not equivalent to DARA4. In fact, it is equivalent to the much stronger constant absolute risk aversion hypothesis. This is proven in the following theorem:

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THEOREM 4: Let V satisfy Assumptions 1 and 2. Then thefollowing statements are equivalent: (a) V satisfies DARA4'. (b) V has the functional form (7).

Finally, consider the following antithesis of DARA4: DARA4": vrj> ir, if V(Fj)
?

V(F;).

Here risk premia are larger for preferred base distributions. This hypothesis is a special case of R-DARA where R = {(Fi, F;) E D2[O, M]: V(Fj) > V(F;)}. Theorem 1 applies and so V must be a mean-variance utility function even though DARA4" requires increasing ratherthan decreasing risk aversion. This hypothesis is included here to illustrate the point made in the last section regarding the proper interpretation of Theorem 1. 4.3. A Final Hypothesis The final specialization of R-DARA considered is DARA5: vrr if either (a) ,u(Fj)> tt(F;) and V(Fj)< V(F,), or (b) DARA5: < .L (Fj) ,L(F;) and V(Fj,4) < V(F;), A- (F;) - g(Fj)
7 in either of two cases. In the first (a), y is DARA5 requires that 17j preferable even though x has a larger mean. Thus intuitively speaking x involves greater variability at least as the latter is measured by V. The risk premium is smaller for the preferred base distribution -, given that it has smaller variability. In the second case (b), is preferred tox + A even though they have equal means. Speaking loosely again, is less variable than x + A and hence also than x. Again the risk premium is smaller for the preferred base distribution if it has smaller variability. This interpretation of DARA5 shows clearly the intuitively plausible way in which it weakens DARA4, where the risk premium was always required to be smaller for the preferred base distribution. DARA5 is also stronger than both the Arrow-Pratt and Ross hypotheses, but it is not comparable to Machina's DARA3. It is, however, a special case of the R-DARA postulate of Theorem 1, since R can be defined to be the union {(Fi, F4) E D2[O, M]: , (F) > ,u(F;) and (F) - (F) > 0 and V(F;) > V(F;) > V(F, )} u {(Fi, F;) E D2[, M]: a V(Fj+A)}. R defined in this way satisfies R.1 and R.2 and R-DARA is equivalent to DARA5 (as long as Assumptions 1 and 2 are maintained). Thus only meanvariance utility functions are consistent with DARA5. The next theorem describes precisely the class of utility functions that satisfy DARA5.

THEOREM 5: Let V satisfy Assumptions 1 and 2. Then thefollowing statements are equivalent: (a) V satisfies DARA5. (b) V has the mean-variance functional form (5) where v is quasiconcave and - v2/ vI is increasing in cr2 and decreasing in ,.

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The mean-variance utility functions described in (b) are those having convex indifference curves and for which both ,t and U2 are normal goods. DARA5 provides an axiomatization for this common specification.
5. ASSET DEMAND CONDITIONS

Previous formulations of DARA have been shown to be equivalent to appropriate forms of decreasingly risk averse behavior in the context of simple portfolio problems. This section establishes such an equivalence for each of the special R-DARA postulates of the last section. The typical portfolio problem considered involves two assets, represented by x and -,where z = x + r + e, r > 0, and E[e/x] = 0 for all x. The asset corresponding to z has a higher mean and greater variability (in the sense of [12]). The portfolio problem is to choose the value of a which yields the most preferred distribution of the form F(1a)j?aj = Fz+a(r+J). If a is unrestricted, then FR+a,(r+9)will be outside D[O, M], the domain of V,for some values. Thus there must be an implicit constraint on a such that FR+a(r+0) lie in D[O, M]. The constraint set always takes the form of a closed interval. To rule out cases in which the interval degenerates to a point assume that Fj has compact support. If also Fz is restricted to lie in D[M, M] for some 0 < M < M < M, then the interval will include zero in its interior. Given risk aversion the optimal value of a is nonnegative so that only nonnegative values of a in the constraint set need be considered. Thus it may be assumed that a varies over an interval [0, bo], where bomax {a: FX+a,(r+j) ED[O,M]}. An optimal value ao of a will be said to be an interior solution if ao < bo. Assets demands in the above portfolio problem are compared to demands in a new problem where the same assets are available but where a stochastic ex post increment to wealth, Ax, is expected. Similar assumptions, notation, and terminology are adopted for this problem; for example, b, max {a: FR,+,+a(r+e)E D[O, M]}, and a solution al is interior if it is less than bl. Fix a set R as in Theorem 1. The following property of asset demands (decreasingly risk averse behavior, or DRAB) is the focus of this section: R-DRAB: Suppose F* and Fz+,dzare in D[M, M] for some 0 < M < M < M, r 0, Fe has compact support, and E[e/x] = E[e/Ax]= 0 for all x and Ax. Let z = x r+e and suppose that ao and al yield the most preferred distributions of the form F(1-a)j+, and F(l-a)x+zlx+a! respectively. Denote by Fo and F1 the corresponding optimal distributions. Then (FO, F1) eR implies that ao0 a1 or
ao> a, = bl.

The interpretation of this condition is straightforward: the expectation of the stochastic increment Ax will cause a revision of the portfolio. But if (FO,F1) E R, and if it is not the case that a0> b1 = a1, then ao< a1 necessarily. In particular, if al is an interior solution, then (FO,F1) E R implies that the new optimal portfolio cannot involve less risk taking, which is a form of decreasingly risk averse

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behavior. The need to include the alternative possibility, where a0o>a1, is easily understood. The relative sizes of ao and a1Idepend not only on whether preferences are decreasingly risk averse but also on the relative severity of the constraints imposed on a in the two problems. In the event that ao> a1 = bl, the reverse inequality ao> a 1 reflects the tighter (b, < bo) and binding (a1 = b,) constraint on a in the problem with the ex post increment, rather than increasingly risk averse behavior. Interpret R-DRAB again for each of the three specifications for R adopted in the last section. (Throughout restrict attention to interior solutions.) If R = D2[0, M], the constant absolute risk aversion case, then R-DRAB asserts that the demand for the riskier asset is unaffected by the ex post increment. For the R that corresponds to DARA4, R-DRAB asserts that preferred optimal portfolios cannot involve less risk taking, i.e., V(FO)- V(F1) implies a0o a1. The 0 which is the case considered ranking indicated by V(FO)- V(F1) is valid if ax 0, in [7]. But the restriction Ax - 0 is severe, e.g., it excludes all cases in which the ex post increment assumes small negative values only on a set of small measure. Thus DARA3 (and a fortiori DARAI and DARA2) are not strong enough to imply "decreasingly risk averse" behavior in a large variety of realistic situations, where the hypotheses formulated in this paper have predictive power. Finally, let R correspond to DARA5. Then R-DRAB requires that the demand for the riskier asset increases as a result of the ex post increment if F1 is preferred to Fo and if F1 is also less variable than Fo in the sense of the discussion in Section 3.3. To prove the equivalence between R-DARA and R-DRAB, the following additional assumption, adapted from [7], is required:
AssuMPTION

over {FE+a(r+e)

3: For all r, x, and e as in the statement of R-DRAB, preferences D[O, M]}af are strictly quasiconcave in a.

Machina calls this property diversification. It ensures that there is a unique optimal value for a and that preferences are strictly decreasing in a below this value and, if the solution is interior, strictly decreasing above it. The final result of this paper is that, under suitable assumptions, R-DARA and R-DRAB are equivalent hypotheses.
THEOREM 6: Let V satisfy Assumptions 1 and 2 and let R satisfy R. 1 and R.2 of Theorem 1. Then R-DARA implies R-DRAB. Moreover, if V also satisfies Assumption 3, and if R is the set for the constant absolute risk aversion postulate, DARA4 or DARAS, then R-DARA and R-DRAB are equivalent hypotheses about V.

A prime justification for considering the constrained portfolio problems above is that they permit the characterization, in terms of asset demand conditions, of decreasing risk aversion on a domain D[O, M], M <coo. However, in common formulations of portfolio problems such constraints are not imposed on a since

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the domain of the utility functional is taken to be suitably unrestricted. Thus it may be worthwhile to provide furtherjustification for the analysis in this section. Firstly, note simply that the constraints are irrelevant given interior solutions, in which case Theorem 6 shows that R-DARA implies decreasingly risk averse behavior, and in environments in which DARA1-DARA3 have no predictive power. Indeed, since mean-variance utility implies the separation property, RDARA has predictive power even in models with more than two risky assets. (See [3].) The complexity introduced by boundary conditions can be avoided if it is desired only to establish asset demand conditions that are necessary, but not sufficient, for R-DARA. Secondly, it is possible to modify the preceding analysis slightly so that it conforms more closely to standard formulations of portfolio problems. For concreteness, consider the special cases of R-DARA and R-DRAB that correspond to the R of DARA4. Adopt the usual assumption that the domain of the utility functional is sufficiently large that constraints on a are unnecessary. Indeed utility functionals often admit natural extensions from some D[O, M] to a larger subset of D[O, ac] which does not require that the supports of all distributions lie in a given compact set. (For example, V(F) from (9) is well-defined for any F that has finite mean and variance.) Denote by V the extension of V. Theorem 1 and the subsequent discussion show that V cannot satisfy DARA4 and be increasing and risk averse, over its entire domain. Suppose therefore, that monotonicity is violated on D[O, M'] for any M'> M But the interpretation of DARA4 as a description of decreasing risk aversion depends on utility being increasing. In fact, if preferences are decreasing then DARA4 describes a form of increasing risk aversion. It follows that V exhibits decreasing risk aversion only on D[O, M] where it coincides with V. Turn to the appropriate unconstrained optimization problems maxa V(FR+a(r+,))and maxa V(FR+=?*+a(r+,)). Denote optimal values of a by ao and aI respectively and consider what statement about these demands corresponds to the decreasing risk aversion of V on D[O, M]. Let bo and b, be defined as above. Then bo, for example, is the maximum value of a in the initial portfolio problem for which the corresponding wealth distribution F*+a(r+0) remains in the region where V is increasing. It is quite conceivable that a> bo or a > bl, or both, in which case the corresponding wealth distributions do not lie in the region where V exhibits declining risk aversion. Thus one would not expect to be able to prove that a 6 a in all cases. But it can be shown that, given the appropriate diversification assumption, the following modification of R-DRAB is both necessary and sufficient for V to exhibit DARA4 on D[O, M]: > V(F+.+61 (r+-) ) > V(FR+&0(r+9)) implies either (i) a &a, or (ii) a&> &, b1. University of Toronto

received received January, 1984; revision July,1984. Manuscript

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APPENDIX Proofs of all theorems are collected here.

PROOF OF THEOREM 1: Adapt the arguments in the proof that (ii)=*(i) in Theorem I of [7; pp. 1076-7]. Fix 0 < M < M < M. SupposethatA(y; F2) < 2/ < A(y*; FF.) wherey $ y*, (F2, FzF) E R, y and y* lie in [M, M] and FF, FF lie in D[M, M]. Then

{V[(l -p)Fi+pei3+

G y+fe++pef3+?Gy<e+pe,]

-V[(1-p)F++pGV]}

>0

for sufficiently small e > 0. (Since F2, F2F, Gq, and Gy lie in D[M, M], the first argument of V will lie in D[O, M] if p and e are sufficiently small.) Repeat with (y, FF) replaced by (y*, FF-) to deduce that for all sufficiently small p, e > 0, (10) (I 1)

V[( l-p)Fj+pe3
V [(I I-P) F+pej3

+- Gy+fe+pe

+ 2 GV.f+pe

j> V[(I -p)F;F+pG],

and

)K*+/+pefl

y-,Ie+pe<

V[(I-p)FZ-+pG0.V].

There exists a distribution F;, for which F; = FF and Fp+g= FF*. (Machina required that i 2 O, but that is not necessary here.) Define Fz ax and Fj, ,x( ./ x, Ax) precisely as in [7]. In particular, (12) Fx=(1-p)Fj+pGq, and Fj+,AX=(1-p)F2*+pG,*. Both Fj and FX+ j are in D[O, M]. Moreover, F,+j+pe,0 and F;+A;X+j+Pe,3are given by the arguments of V on the left sides of (10) and (11) respectively. Thus, as noted above, they also lie in D[O, M]. < Finally, it follows from (10) and ( 11) that vrz < pe,83 7TjK+d:z The inequality 7r; < 7vz+& is valid as long as p above is chosen sufficiently small. Since (F., E R if 0 < p < p. Thus the above inequality F2F) E R, R. 1 and (1 2) imply that 3p such that (Fl, F_j+A;X) for risk premia contradicts R-DARA. This proves that for all 0<M<M<M, A(y; F2) A(y*; F2*) if y, y*E[M, M], F2, FF*e D[M1,M], and (FF, F2*) E R. Since A(x;.) is continuous (Assumption 2), straightforward limiting arguments prove (4). Condition R.2, (4), and the continuity of A imply that A(y; F) 2 A(y*; F)Vy, y* E [0, M] and VFe D[O, M]. Thus A is independent of its first argument. By the definition of A, the local utility function U(*; F) is quadratic VFe D[O, M]. To prove the existence of a function v as in (5) it suffices to prove that VF, G E D[O, M], (F) = (G) = t and o-2(F) = a2(G) = ?2' V(F) = V(G). This is accomplished as follows: For Then FP( ;0)=G(.) and F(; 1)=F( ). Thus acE[0, 1], define F(-; a)--aF( )+(l-a)G(.). = 0 for all a E [0, 1]. But the latter V(F) = V(G) will follow if it can be shown that dV(F( ; a)/dal, derivative equals I U(w; F( ; a))[dF(w) - dG(w)] which vanishes since U(; F(-; a)) is quadratic and since F and G have common means and variances. The differentiability of v and v, > 0, v2 :0 follow from Assumption 1. The local utility function U can be written in the following form:

(13)

U(y; F)

=[v,(,u (F), o2(F)) - 2v2 (g(F),

+y2v2(9

_2 (F))

wdF(w)]y

(F),

c_2(F)).

Equation (6) follows from (2) and (13).

Q.E.D.

PROOF OF THEOREM 3: (b)?=(a) is trivial since 7Ti can be computed explicitly and equals aa-2(FE). (a)?'(b): By (4), A is constant in both arguments so (6) -v2/vI = a O0for some constant a. Q.E.D. Integration yields (7). PROOF OF THEOREM 3: (b)=*(a): Each indifference curve of v is a straight line. Therefore, 7Tz can be computed explicitly and equals k(v(F,)) * &2(F;). This implies DARA4.

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(a)?(b): (14) (15)

From (4), A(y; F):A(y; A(y; F)=A(y; G) G) if if V(F)< V(G), V(F)= V(G). is decreasing because of (6) and (14). The remaining Q.E.D. and

Equations (5), (6), and (15)=X - V2 V =(v). Ci properties of q follow from Assumption 1.
PROOF OF THEOREM 4: (b)?i(a)

is trivial. (a)?(b): A slight adaptation of the proofs of Theorems I and 3 proves (14), (15) and hence that = + (v) as in Theorem 3. U(. ; F) is quadratic, V is a mean-variance functional and that -V2VI Indeed this adaptation is closer to Machina's original arguments [7; pp. 1076-7] since he uses the risk premium vF rather than ire. It remains only to prove that k is constant. Fix A, a-2and 6-v(,u, a2). Define H(a, A) v(f(a), , where f is defined implicitly by v(f(a), o.2+ a) = 6. Clearly, f(O) = A and , -2)/vI(A,' c2). Differentiate H f'(0) =-v2( with respect to a and evaluate at a = 0 to obtain (16) Ha(0, a) = vl(,c, 2+A)[+(6)
-

f(V(.,

a2+a))].
+

Suppose that 0 is not constant in a neighborhood of v. Since (17) +(v) #5 (v( (,A'-2+ a)) $0(v(f(a), a-2+ a+A))

is decreasing 3a and a > 0 such that VO< a <C and

< 0< a a.

Since ' is decreasing, (16) and (17)?Ha(0, A) < 0. Thus 3a and A > 0 such that (17) and H(a, A) < H(0, A). The latter implies, by the definition of H, that

(18)

v(f(a),

-2+

a +A) < v(u,o-2+ A).

aR2+

Define x, y, and e so that a 2(Fj) = A, u (FX) = Ac,a-2(Fj) = a2, a-2(F5) = (17), (18) and the definition off, (19)

a, A(F;) =f(a).

By

V(FX)= V(F9), and V(Fj+j)> V(F9+,F), V(Fj+ j))<c(V(Fj+e)). Since x and y are indifferent, vR= v;. On the other hand the last inequality in (19) implies that v:z< v'l, a contradiction. To see the latter, recall that v has linear indifference curves. Thus the equation v( ji(F:) - v*, a2(F,j)) = v(p,(Fg), a-2(Fg) + a-2(Fg)) can be solved explicitly to yield vg = a-2(F.-) *( V(F,-+j)). A similar expression may be derived for v;f. Thus vg < vi'l follows from (19). Hence 4 must be constant in a neighborhood of 6. Since 6 was arbitrary, 4 is constant and hence
SO iS -V2/V1-

Q.E.D.

Follows readily by inspection of the indifference map for v. (a)=>(b): Theorem 1 implies the existence of a function v. The desired properties of v are readily verified. For example, to show v is quasiconcave, let v(It, a-i) = v(A2, 2), /2> jt1. Let F1 and F2 have these means and variances respectively, and let R be the set defined in the text prior to the statement of Theorem 5. Then (F2, F,) E R. By (4), A(y; F) a A(y; G)V(F, G) E R. Thus A(y; F2) ? A(y; F1) by the continuity of A (Assumption 2). By (6), therefore,
V2
_ 2 V1

PROOF OF THEOREM 5: (b)?(a):

2, V2a _2 -2sa2)

V1

(a 1, 0-2)

which proves that the given indifference curve is convex.

Q.E.D.

PROOF OF THEOREM 6: R-DARA?iR-DRAB: V must be a mean-variance functional. Thus the first order condition for an optimal portfolio yields

al = r/[a-2(F&) * (-2!2(L(Fj)+A,u(F1Z)+alr,
+a -2(Fe))]

-2(F)

+ a-2(FX)

if

a1<bl,

and

ao,- r/[a2(Fj)(

-2 v2 (,(FZ) + aor, 2(FR) +c2(Fj)))].

Now apply (4) and (6). R-DRAB?R-DARA: First prove (4). R.2 and the openness of R are given.

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Suppose 3y, y*, F7, Fw*such that (Fw, Fw*) E R, y, y* E [M, M], F, Fw* e D[A, M] for some 0 < M < M < M, and such that A(y; F -) < A(y*; F -*). Adapt Machina's [7; pp. 1078-9] proof that (iii) =(i) in his Theorem 1, in the same way that the proof of Theorem 1 of this paper was constructed from his arguments. In particular, find a > 0 and 3 > 0 such that
2

(y + C; Fw,) - U,(y - ; Fw,)] -8[U, | Uj(e; Fw-)dFW,(6) y*/&c,(M-y)/i, 8, My -8

/

--2[U,(y

+ d; Fw*-)- U,(y*; |U,(e; Fw*-) dFT,.(6)

and

*)

Fix 8>0 such that 8<min{y/l, L<min Define (19) (a ; p)

(M-y*)/&},

{M/as C,a_

V[(l -p)Fw+pP(a-5)+2pGy+(pP+-8)a

+-2PGy+(pP-8)a],

for p =0 and all a, or 0 <p<L

b(p)-max

and 0 < ab(p),

Gy+(pp8+8)a3, Gy+(ppS-,)a all lie in D[O, M]}.

{a> 0: Fw+Pp3(c),

By the choice of 8 and L, (0, p) and (ci, p) lie in the domain of i <b(p) for all pe (0, L]. Also, (20) b(p) s--(M - y) 1
VP e (O,L].

k for each p in [0, L). In particular,

Define >* as in (19) with iw and y replaced by iv* and y* respectively. The domain of 40* is described by a function b*(p) defined in the obvious fashion. Again, (O,p) and (Ci,p) lie in the domain of 0* for pEX [0, L) and (21) b*(p) s (M -y*)/8 Vp E (0, L].

For each p e (0, L), consider (22) max {4(a; p): 0 s a < b(p)}.
CK

As in Machina, this optimization problem can be expressed as a portfolio problem. In fact, the latter has precisely the form described in the statement of R-DRAB. By Assumption 3, therefore, the optimal value of a is unique and is denoted al(p). Denote by c*(p) the solution to the corresponding problem involving k*. Let H(p) denote the distribution on the right side of (19) when cr(p) is substituted for a, and define H*(p) similarly. Note that H(p) -> FWand H*(p) -> Fw* as p - 0, in the Ll norm on D[0, M]. (Make use of the fact that a( p)sb(p) S (M-y)/8 and C*(p) < b*(p) s (M-y*)/8 for all pe (0,L).) By hypothesis, (FW,FW*)eR. Thus 3p such that (H(p), H*(p))ER VO<p<p, and so R-DRAB implies that Vp, 0 <p <p, (23) a ( _p< a(P) or a (p)> a(p) b*(p).

On the other hand, Machina shows 3p such that 0 < p< p (a, p) > 0 and (cr,p) < 0. Apply (p) >i t a=d a*( p)< Assumption 3 again to deduce that 0c< p< c b*(p), which contradicts (23). Therefore, A( y; F-) > A( y*; F-*) for all y, y*, Fw, Fw* as specified at the beginning of the proof. Limiting arguments like those used in the proof of Theorem 1 establish (4). Equations (5) and (6) are implied by (4). In particular, V must be a mean-variance functional. Suppose R corresponds to DARA4. Then argue as in the proof of Theorem 3 that V has the particular functional form in Theorem 3(b). Thus by "(b)?.(a) in Theorem 3," V satisfies DARA4. Similarly Theorems 2 and 4 can be applied if R corresponds to constant risk aversion or to DARA5. Q.E.D. REFERENCES [1] ARROW,K. J.: Essays in the Theoryof Risk-Bearing. Amsterdam: North-Holland, 1974. [2] CHAMBERLAIN, G.: "A Characterization of Distributions that Imply Mean-Variance Utility Functions," Journal of Economic Theory,29(1983), 185-201.

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[3] HART, 0. D.: "Some Negative Results on the Existence of Comparative Statics Results in Portfolio Theory," Review of Economic Studies, 42(1975), 615-621. [4] MACHINA, M. J.: "The Economic Theory of Individual Behaviour Toward Risk: Theory, Evidence and New Directions," Report 433, Stanford University, IMSS, 1983. [5] "Temporal Risk and the Nature of Induced Preferences," Journal of Economic Theory, 33(1983), 199-231. : "'Expected Utility' Analysis Without the Independence Axiom," Econometrica,50(1982), [6] 277-323. "A Stronger Characterization of Declining Risk Aversion," Econometrica, 50(1982), [7] 1069- 1079. : "The Behaviour of Risk Sharers," mimeo, University of California at San Diego, 1984. [8] R.: "Optimum Consumption and Portfolio Rules in a Continuous-Time Model," [9] MERTON, Journal of Economic 7heory, 3(1971), 373-413. [10] PRATT, J. W.: "Risk Aversion in the Small and the Large," Econometrica, 32(1964), 122-136. [11] Ross, S. A.: "Some Stronger Measures of Risk Aversion in the Small and the Large with Applications," Econometrica, 49(1981), 621-638. "Increasing Risk: I. A Definition," Journal of Economic [12] ROTHSCHILD, M., AND J. STIGLITZ: Theory, 2(1970), 225-243. [13] WILLIG,R.: "Risk Invariance and Ordinally Additive Utility Functions," Econometrica,45(1977), 621-640.