City Research Online

Risk exchange with distorted probabilities

Tsanakas, A. & Christofides, N. (2006). Risk exchange with distorted probabilities. Astin Bulletin, 36(1), pp. 219-243. doi: 10.2143/AST.36.1.2014150


An exchange economy is considered,where agents (insurers/banks) trade risks. Decision making takes place under distorted probabilities, which are used to represent either rank-dependence of preferences or ambiguity with respect to real-world probabilities.Pricing formulas and risk allocations,generalising the results of Bühlmann (1980,1984) are obtained via the construction of aggregate preferences from heterogeneous agents’ utility and distortion functions. This involves the introduction of a novel ‘collective ambiguity aversion’ coefficient. It is shown that probability distortion changes insurers’behaviour, who trade not only to share the aggregate market risk, but are also found to bet against each other.Moreover,probability distortion tends to increase the price of insurance (increase asset returns). While the cases of rank-dependence and ambiguity are formally similar,an important distinction emerges as for rank-dependent preferences equilibria are determinate, while for ambiguity they are generally indeterminate.

Publication Type: Article
Additional Information: Copyright Cambridge University Press, 2006. This version may have been revised following peer review but may be subject to further editorial input by Cambridge University Press.
Subjects: H Social Sciences > HF Commerce
Departments: Bayes Business School > Actuarial Science & Insurance
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