INSTITUTE USB

DEPARTMENT BBA
Behavioral and Personal Finance
Code- 20BAY 268
Faculty Name: Akhilender Singh

Non Expected Utility Preferences and its DISCOVER . LEARN . EMPOWER

Applications in Finance
 Course Objective
The objective of this course is to impart in-depth
knowledge to the students regarding the aspects of
behavioral financial decision making and personal
finance planning.
Course Outcome
CO Title Level
Number
CO1 Ability to understand the concept Remember
of behavioral and personal finance Source: https://www.google.com/search?
sxsrf=AOaemvLVb1oXk9LwQY60QR98ll8foRr
PCg:1643188975854&source=univ&tbm=isch&
CO2 Understanding the techniques, Understand q=images+of+behavioral+and+personal+finance
&fir=e5rEJZruGgQ-VM
approaches and theories in %252COrcj9daWgCBO9M%252C

behavioral and personal finance.

NON EXPECTED UTILITY IN FINANCE
The expected utility/subjective probability model of risk preferences and
beliefs has long been the preeminent model of individual choice under
conditions of uncertainty. It exhibits a tremendous flexibility in
representing aspects of attitudes toward risk, has a well-developed
analytical structure, and has been applied to the analysis of gambling,
games of strategy, incomplete information, insurance, portfolio and
investment decisions, capital markets, and many other areas. This model
posits a cardinal utility function over outcomes (usually alternative
wealth levels) and assumes that an individual evaluates risky prospects on
the basis of the expected value of his or her utility function.

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NON EXPECTED UTILITY IN FINANCE
In situations of objective uncertainty (e.g., roulette wheels), this
expectation is based on the objective probabilities involved. In situations
of subjective uncertainty (e.g., horse races) likelihood beliefs are
represented by the individual’s personal or subjective probabilities of the
various alternative occurrences. First proposed by the Dutch
mathematician Daniel Bernoulli in 1738 as a solution to the well-
known Saint Petersburg paradox, the expected utility model has since
been axiomatized under conditions of both objective and subjective
uncertainty. Many consider these axioms and the resulting model to be
the essence of rational risk preferences and beliefs.

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NON EXPECTED UTILITY IN FINANCE
In spite of its flexibility, the expected utility/subjective probability model
has refutable implications, and beginning in the 1950s, psychologists and
economists have uncovered a growing body of experimental evidence
that individuals do not necessarily conform to many of the key axioms or
predictions of the model. One well-known example, first demonstrated by
the French economist Maurice Allais in 1953.

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NON EXPECTED UTILITY IN FINANCE
Consists of asking subjects to express their preferred option from each of
two pairs of objective gambles. The majority of subjects express
preferences that are inconsistent with expected utility, and they directly
violate its primary empirical axiom, the so-called independence axiom.
Although initially dismissed as an isolated example, the Allais paradox
has been replicated by numerous researchers and found to be a special
case of at least two forms of systematic violations of the independence
axiom. Such departures have also been replicated using real-money
gambles.

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NON EXPECTED UTILITY IN FINANCE AND
IT’S APPLICATIONS
Since the work of von Neumann and Morgenstern (1944) expected
utility (EU) has been the dominant framework for analyzing decision
situations under risk and uncertainty. Starting with the well-known
paradoxes of Allais (1953) and Ellsberg (1961), however, a large body
of experimental evidence has been gathered which indicates that
individuals tend to violate the assumptions underlying EU
systematically. This empirical evidence has motivated researchers to
develop alternative theories of choice under risk and uncertainty able
to accommodate the observed patterns of behavior. These models are
usually referred to as nonexpected utility. Nowadays the rank-
dependent models, in particular prospect theory, have become the most
prominent alternative and, accordingly.
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NON EXPECTED UTILITY IN FINANCE AND
IT’S APPLICATIONS
These models will also be the main focus of our paper. If the decisions
of subjects are not in line with EU, applied models which rest on it
may make wrong predictions. Therefore, applications of non-expected
utility models may lead to a better accommodation of real world data.
In general, applications of non-expected utility can be regarded as part
of behavioral economics, a research stream which integrates
psychological concepts into economics analysis and has received
increasing attention in recent years.

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 NON EXPECTED UTILITY IN FINANCE AND
IT’S APPLICATIONS
Non-expected utility models can in principle be applied to every
economic setting involving risk. Due to this fact, it is impossible to
cover all fields of applications in the present article. We have decided
to focus on three fields, insurance economics, auctions, and health
economics. Health economics is treated more extensively than the two
other fields because it has become recently a very important research
topic and to our knowledge no review of applications non-expected
utility in the health domain exists. The article is organised as follows.
Section 2 gives notation and basic concepts. Section 3 describes
expected utility and Section 4 describes important non-expected utility
models.
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 NON EXPECTED UTILITY IN FINANCE AND
IT’S APPLICATIONS
Applications of non-expected utility in auctions Due to the increasing
importance of auctions in the real world, the literature on auctions has
grown rather rapidly in recent years. Since the analysis of many auction
designs like combinatorial auctions is rather complex even for risk neutral
bidders, applications of non-expected utility are rare in this context. In the
present chapter we will focus on auctions of a single object and stick to the
independent private values framework. In this framework each bidder i has
a private valuation vi of the auctioned object Z which is not known by the
other bidders. Formally, we have [Z – vi] ~ δ0 where [Z – vi] denotes
receiving the object for paying vi. All valuations are drawn from the same
distribution over an interval [v+ , v- ]. first-price second-price open bids
descending bid auction ascending bid auction sealed bids first-price sealed-
bid auction second-price sealed-bid auction
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 NON EXPECTED UTILITY IN FINANCE AND
IT’S APPLICATIONS

• Applications of non-expected utility in the health domain Utility theory is

widely applied in medical decision making. The common way to evaluate new
medical technologies is through cost-utility analysis in which the benefits of
these technologies is expressed in terms of utility. The most popular utility
model is the quality, adjusted life-years (QALY) model. The QALY model
combines the two dimensions of health, 13 life duration and health status, in a
single index number and claims that the utility of a T years in health state Q is
equal to (15) U(Q,T) = V(Q)*T, where V(Q) denotes a weight that reflects the
utility (or attractiveness) of health state Q. QALYs play an important role in
health policy in many countries. For example, in the UK the National Institute
for Clinical Excellence (NICE) requires a cost-utility analysis based on
QALYs before a treatment is eligible for inclusion in the NHS.
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 REFERENCES
• Reference Books
1. Behavioral Finance, William Forbes, Wiley, 2019
2. Behavioral Finance Psychology, Decision-Making and Markets, L.F. Ackert and
R. Deaves, South-Western College Publication.

• Reference Website
• https://www.slideshare.net/sonicshare/vouching-and-verification-72048613
• https://www.oreilly.com/library/view/auditing-principles-and/9789332501447/xht
ml/chapter006.xhtml
• https://accountlearning.blogspot.com/2012/02/concept-of-verification-and-valuati
on.html

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 SUMMARY
• The behavioral and personal finance help the investor in a financial
market in making financial decisions and personal financial planning.  
• Prior to the crisis, the behavioral and personal finance was not subject to
an effective regulatory regime. There was an over abundance of bilateral
credit risk and trades were under-collateralized. As the collapse of AIG
demonstrated, this inferior market structure quickly became a source of
risk. 
• As the regulatory process continues, investors must seek to ensure that
the financial market is a venue to manage risk with the help of behavioral
and personal finance concept.

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THANK YOU

For queries
Email: akhilender.e9369@cumail.in