This dissertation contains three essays on learning and risk aversion. In the first essay we consider how learning may lead to risk averse behavior. A learning rule is said to be risk averse if it is expected to add more probability to an action which provides, with certainty, the expected value of a distribution rather than when it provides a randomly drawn payoff from this distribution, for every distribution. We characterize risk averse learning rules. The result reveals that the analysis of risk averse learning is isomorphic to that of risk averse expected utility maximizers. A learning rule is said to be monotonically risk averse if it is expected to increase the probability of choosing the actions whose distribution second-order stochastically dominates all others in every environment. We characterize monotonically risk averse learning rules. In the second essay we analyze risk attitudes for learning within the mean-variance paradigm. A learning rule is variance-averse if the expected reduced distribution of payoffs in the next period has a smaller variance than that of the current reduced distribution, in every set where all the actions provide the same expected payoff. A learning rule is monotonically variance-averse if it is expected to add probability to the set of actions that have the smallest variance in the set, when all the actions have the same expected payoff. A learning rule is monotonically mean-variance-averse if it is expected to add probability to the set of actions that have the highest expected payoff and smallest variance whenever this set is not empty. We characterize monotonically variance-averse and monotonically mean-variance-averse learning rules. In the last essay we analyze the social learning process of a group of individuals. We say that a learning rule is first-order monotone if the number of individuals that play actions with first-order stochastic dominant payoff distributions is expected to increase. We characterize these learning rules.

No / It is demonstrated that small marketable gambles that are unattractive to a Standard Risk Averse investor cannot be made attractive even if certain independent background risks that decrease expected marginal utility are added.

This dissertation is an investigation into the determinants of demand for service contracts on new vehicles. In the first chapter, I characterize the consumer decision to buy a service contract with a discrete choice model. Hypotheses and conjectures are tested empirically using survey data from new vehicle buyers. The second chapter consists of the development and testing of an instrument for measuring attitudes toward uncertainty. This tool is useful in gauging aversion toward weak ambiguity. Finally, in the third chapter, I use additional survey and experimental data from new vehicle buyers to further differentiate between the factors that significantly affect the service contract purchase decision. A variety of uncertainty measures and their predictive powers are discussed. I would like to thank the John D. and Catherine T. MacArthur Foundation, Network on Preferences and Norms, for their generous financial support, which was indispensable to the completion of this research. / Ph. D.

Abstract Employee stock option had been discussed for long time and had become very popular topic for current corporates¡¦ financial management. The importance of its option value model becomes hot topic now. The recommended model based on FASB No. 123 may not be helpful to see its payoff distortion from risk aversion and employee exit rate factors. We choose some companies at Taiwan which use employee stock option as their financial tool and study how both risk aversion and employee exit rate impact their value with modified binomial tree method. The results show that risk aversion factor is more sensitivity and cause option payoff change its value within very narrow input range, while employee exit rate also change option value sigfincantly after 10% exit rate range. Hence. Evaluation of risk aversion and employee exit rate factors become important. Companies need to search for optimal solution of those factors to achieve optimal option valuation and its relative incentive effect in order to retain their employee.

This dissertation contains three essays on risk aversion. In the first essay, we an- alyze comparative risk aversion in a new way, through a comparative statics problem in which, for a cost, agents can shift from an initial probability distribution toward a preferred distribution. The Ross characterization arises when the original distribution is riskier than the preferred distribution and the cost is monetary, and the Arrow-Pratt characterization arises when the original distribution differs from the preferred distribution by a simple mean-preserving spread and the cost is a utility cost. Higher-order increases in risk lead to higher-order generalizations, and the com- parative statics method yields a unified approach to the problem of comparative risk attitudes. In the second essay, we analyze decisions made by a group of terrorists and a government in a zero-sum game in which the terrorists minimize a representative citizen's expected utility and the government maximizes it. The terrorists' strategy balances the probability and the severity of the attack while the government chooses the level of investment reducing the probability and/or mitigating the severity. We find that if the representative citizen is risk neutral, the terrorists' response is not associated with the government's action and the representative citizen's risk attitudes affect the strategies of the government and the terrorists. Risk aversion always in- creases equilibrium severity but does not always increase equilibrium expenditure of the government. In the last essay, we consider a situation in which an individual has to pay for a good before he realizes the state-dependent surplus of the good. This ex-ante willingness to pay is called the option price and the difference between the option price and the expected surplus is the option value. We find that the option value actually is the buying price for a fixed payment of the expected surplus, and there is a special case in which the option value equals the negative of the compensating risk premium. We also find the effects on the option price and the option value when the expected utility assumption is replaced by a rank-dependent expected utility.

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The pricing of total liquidity risk is studied in the cross-section of stock returns. The study suggests that there is a positive relation between total volatility of liquidity and expected returns. Our measure of liquidity is based on Amihud (2002) and its volatility is measured using daily data. Furthermore, we document that total volatility of liquidity is priced in the presence of systematic liquidity risk: the covariance of stock returns with aggregate liquidity, the covariance of stock liquidity with aggregate liquidity, and the covariance of stock liquidity with the market return. The separate pricing of total volatility of liquidity indicates that idiosyncratic liquidity risk is important in the cross section of returns. This result is puzzling in light of Acharya and Pedersen (2005) who develop a model in which only systematic liquidity risk affects returns. The positive correlation between the volatility of liquidity and expected returns suggests that risk averse investors require a risk premium for holding stocks that have high variation in liquidity. Higher variation in liquidity implies that a stock may become illiquid with higher probability at a time when it is traded. This is important for investors who face an immediate liquidity need and are not able to wait for periods of high liquidity to sell.

Second order stochastic dominance is an optimal rule for portfolio selection of risk averse investors when we only know that the investors' utility function is increasing concave. The main advantage of SSD is that it makes no assumptions regarding the return distributions of investment assets and has been proven to lead to utility maximization for the class of increasing concave utility functions. A number of different SSD models have emerged in the literature for portfolio selection based on SSD. However, current SSD models produce the same SSD efficient portfolio for all risk averse investors, regardless of their risk aversion degree. In this thesis, we have developed a new SSD efficiency model, SSD-DP, which unlike existing SSD efficiency models in the literature, provides an SSD efficient portfolio as a function of investors' risk aversion degrees. The SSD-DP model is based on the linear programming technique and finds an SSD efficient portfolio by minimizing the dual power transform (DP) of a weighted portfolio of assets for a given risk aversion degree. We show that the optimal portfolio of the proposed model is SSD efficient, i.e. it is not dominated by SSD by any other portfolio, and, through empirical studies of historical data, we show that the method is a promising tool for constructing trading strategies.

Second order stochastic dominance is an optimal rule for portfolio selection of risk averse investors when we only know that the investors' utility function is increasing concave. The main advantage of SSD is that it makes no assumptions regarding the return distributions of investment assets and has been proven to lead to utility maximization for the class of increasing concave utility functions. A number of different SSD models have emerged in the literature for portfolio selection based on SSD. However, current SSD models produce the same SSD efficient portfolio for all risk averse investors, regardless of their risk aversion degree. In this thesis, we have developed a new SSD efficiency model, SSD-DP, which unlike existing SSD efficiency models in the literature, provides an SSD efficient portfolio as a function of investors' risk aversion degrees. The SSD-DP model is based on the linear programming technique and finds an SSD efficient portfolio by minimizing the dual power transform (DP) of a weighted portfolio of assets for a given risk aversion degree. We show that the optimal portfolio of the proposed model is SSD efficient, i.e. it is not dominated by SSD by any other portfolio, and, through empirical studies of historical data, we show that the method is a promising tool for constructing trading strategies.

My dissertation consists of three essays. The central theme of these essays is the psychological factors and biases that affect the portfolio allocation decision. The first essay entitled, “Are women more risk-averse than men?” examines the gender difference in risk aversion as revealed by actual investment choices. Using a sample that controls for biases in the level of education and finance knowledge, there is evidence that when individuals have the same level of education, irrespective of their knowledge of finance, women are no more risk-averse than their male counterparts. However, the gender-risk aversion relation is also a function of age, income, wealth, marital status, race/ethnicity and the number of children in the household. The second essay entitled, “Can diversification be learned?” investigates if investors who have superior investment knowledge are more likely to actively seek diversification benefits and are less prone to allocation biases. Results of cross-sectional analyses suggest that knowledge of finance increases the likelihood that an investor will efficiently allocate his direct investments across the major asset classes; invest in foreign assets; and hold a diversified equity portfolio. However, there is no evidence that investors who are more financially sophisticated make superior allocation decisions in their retirement savings. The final essay entitled, “The demographics of non-participation”, examines the factors that affect the decision not to hold stocks. The results of probit regression models indicate that when individuals are highly educated, the decision to not participate in the stock market is less related to demographic factors. In particular, when individuals have attained at least a college degree and have advanced knowledge of finance, they are significantly more likely to invest in equities either directly or indirectly through mutual funds or their retirement savings. There is also evidence that the decision not to hold stocks is motivated by short-term market expectations and the most recent investment experience. The findings of these essays should increase the body of research that seeks to reconcile what investors actually do (positive theory) with what traditional theories of finance predict that investors should do (normative theory).