Asset Preference and Expected Utility: the Measurement of Some Problems (original) (raw)

1982

Abstract

This paper shows that serious analytical errors may occur in expected utility theory when Taylor series approximation methods are used without careful attention to underlying mathematical assumptions. Recent studies have developed theory incorporating skewness of return into expected utility calculations based on a Taylor series approximation. It is apparent that 'this theory is invalid if assumptions for application of a Taylor series cannot be met. Errors may occur if returns fall outside the region of convergence of the utility function or if the partial sums of the Taylor series provide poor approximations to the utility function. Stylized examples are presented to illustrate miscalculation of utility when the various assumptions are violated. These examples are motivated by the new spectrum of financial securities which allow investors to create almost any desired expected return distribution. Asset Preference and the Measurement of Expected Utility: Some Problems Under ce...

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