TY - JOUR

T1 - Utility theory front to back

T2 - Inferring utility from agents' choices

AU - Cox, A.M.G.

AU - Hobson, D.

AU - Obłój, J.

PY - 2014/5/1

Y1 - 2014/5/1

N2 - We pursue an inverse approach to utility theory and associated consumption and investment problems. Instead of specifying a utility function and deriving the actions of an agent, we assume that we observe the actions of the agent (i.e. consumption and investment strategies) and ask if it is possible to derive a utility function for which the observed behavior is optimal. We work in continuous time both in a deterministic and stochastic setting. In the deterministic setup, we find that there are infinitely many utility functions generating a given consumption pattern. In the stochastic setting of a geometric Brownian motion market it turns out that the consumption and investment strategies have to satisfy a consistency condition (PDE) if they are to come from a classical utility maximization problem. We show further that important characteristics of the agent such as risk attitudes (e.g., DARA) can be deduced directly from the agent's consumption and investment choices.

AB - We pursue an inverse approach to utility theory and associated consumption and investment problems. Instead of specifying a utility function and deriving the actions of an agent, we assume that we observe the actions of the agent (i.e. consumption and investment strategies) and ask if it is possible to derive a utility function for which the observed behavior is optimal. We work in continuous time both in a deterministic and stochastic setting. In the deterministic setup, we find that there are infinitely many utility functions generating a given consumption pattern. In the stochastic setting of a geometric Brownian motion market it turns out that the consumption and investment strategies have to satisfy a consistency condition (PDE) if they are to come from a classical utility maximization problem. We show further that important characteristics of the agent such as risk attitudes (e.g., DARA) can be deduced directly from the agent's consumption and investment choices.

UR - http://www.scopus.com/inward/record.url?scp=84901049678&partnerID=8YFLogxK

UR - http://dx.doi.org/10.1142/S0219024914500186

U2 - 10.1142/S0219024914500186

DO - 10.1142/S0219024914500186

M3 - Article

AN - SCOPUS:84901049678

SN - 0219-0249

VL - 17

JO - International Journal of Theoretical and Applied Finance

JF - International Journal of Theoretical and Applied Finance

IS - 3

ER -