Standard Stochastic Dominance

Research output: Contribution to journalArticle

5 Citations (Scopus)

Abstract

We propose a new Stochastic Dominance (SD) criterion based on standard risk aversion, which assumes decreasing absolute risk aversion and decreasing absolute prudence. To implement the proposed criterion, we develop linear systems of optimality conditions for a given prospect relative to a discrete or polyhedral choice opportunity set in a general state-space model. An empirical application to historical stock market data shows that small-loser stocks are more appealing to standard risk averters than the existing mean-variance (MV) and higher-order SD criteria suggest, due to their upside potential. Depending on the assumed trading strategy and evaluation horizon, accounting for standardness increases the estimated abnormal returns of these stocks by about 50 to 200 basis points per annum relative to MV and higher-order SD criteria. An analysis of the MV tangency portfolio shows that the opportunity cost of the MV approximation to direct utility maximization can be substantial.

Original languageEnglish
Pages (from-to)1009-1020
Number of pages12
JournalEuropean Journal of Operational Research
Volume248
Issue number3
DOIs
Publication statusPublished - Feb 1 2016
Externally publishedYes

Fingerprint

Stochastic Dominance
Risk Aversion
Higher Order
Trading Strategies
Utility Maximization
Linear systems
State-space Model
Optimality Conditions
Stock Market
Horizon
Linear Systems
Standards
Stochastic dominance
Costs
Evaluation
Approximation
Mean-variance

Keywords

  • Decision theory
  • Linear Programming
  • Portfolio theory
  • Standard risk aversion
  • Stochastic Dominance

ASJC Scopus subject areas

  • Modelling and Simulation
  • Management Science and Operations Research
  • Information Systems and Management

Cite this

Standard Stochastic Dominance. / Post, Thierry.

In: European Journal of Operational Research, Vol. 248, No. 3, 01.02.2016, p. 1009-1020.

Research output: Contribution to journalArticle

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