The Case for Limited Auditor Liability - The Effects of Liability Size on Risk Aversion and Ambiguity Aversion

Both the US and the EU consider limiting auditor liability in order to ensure the viability of the audit market, but fear its potentially negative impact on audit quality. Our paper discusses the existing empirical results on this topic in the auditing and behavioral economics literature, and provides new evidence based on a controlled laboratory experiment. Our experiment involves real losses and allows for direct inference of behaviour under limited and unlimited liability in situations of ambiguous liability risk. Our findings imply that limited liability can induce an efficient level of audit effort, while unlimited liability induces an inefficiently high level of audit effort. This paper contributes to the literature on auditor liability, as well behavioral economics research in general, by addressing recent controversial issues on behavior in the presence of ambiguity and real losses.

High-Order Consumption Moments and Asset Pricing

To assess the potential of incomplete consumption insurance for explaining the equity premium and the risk-free rate of return, we use a Taylor series expansion of the individual's marginal utility of consumption around the conditional expectation of consumption and derive an approximate equilibrium model for expected returns. In this model, the priced risk factors are the cross-moments of return with the moments of the cross-sectional distribution of individual consumption and the coefficients of the risk factors are determined by the derivatives of the utility function. Using this approach allows to avoid an ad hoc specification of preferences and to consider a general class of utility functions when addressing the question of the effect of a particular moment of the cross-sectional distribution of individual consumption on the expected equity premium and risk-free interest rate. We demonstrate that if consumers exhibit decreasing and convex absolute prudence, then the cross-sectional mean and skewness of individual consumption help explain the equity premium if their cross-moments with the excess market portfolio return are positive, while the cross-sectional variance and kurtosis always lower the equity premium explained by the model. The empirical investigation uses the data on the monthly household consumption of nondurables and services, reconstructed from the Consumer Expenditure Survey database. The Hansen-Jagannathan volatility bound analysis, calibration, and GMM analysis results show that under the CRRA preferences, the model can reproduce the observed equity premium and risk-free rate with economically plausible values of the relative risk aversion coefficient (between 0.6 and 1.6) and the time discount factor when the cross-sectional skewness of individual consumption, combined with the cross-sectional mean and variance, is taken into accountequity premium puzzle, heterogeneous consumers, incomplete consumption insurance, risk-free rate puzzle.

Asset Pricing Theories, Models, and Tests

An important but still partially unanswered question in the investment field is why different assets earn substantially different returns on average. Financial economists have typically addressed this question in the context of theoretically or empirically motivated asset pricing models. Since many of the proposed “risk” theories are plausible, a common practice in the literature is to take the models to the data and perform “horse races” among competing asset pricing specifications. A “good” asset pricing model should produce small pricing (expected return) errors on a set of test assets and should deliver reasonable estimates of the underlying market and economic risk premia. This chapter provides an up-to-date review of the statistical methods that are typically used to estimate, evaluate, and compare competing asset pricing models. The analysis also highlights several pitfalls in the current econometric practice and offers suggestions for improving empirical tests

Are Estimates of Asymmetric First-Price Auction Models Credible? Semi & Nonparametric Scrutinizations

Structural first-price auction estimation methods, built upon Bayesian Nash Equilibrium (BNE), have provided prolific empirical findings. However, due to the latent nature of underlying valuations, the assumption of BNE is not feasibly testable with field data, a fact that evokes harsh criticism on the literature. To respond to skepticism regarding credibility, we provide a focused answer by scrutinizing estimates derived from experimental asymmetric auction data in which researchers observe valuations. We test the statistical equivalence between the estimated and true value distributions. The Kolmogorov-Smirnov test fails to reject the distributional equivalence, strongly supporting the credibility of structural asymmetric auction estimates

Modeling style rotation: switching and re-switching

The purpose of this paper is to investigate the dynamics and statistics of style rotation based on the Barberis-Shleifer model of style switching. Investors in stocks regard the forecasting of style-relative performance, especially style rotation, as highly desirable but difficult to achieve in practice. Whilst we do not claim to be able to do this in an empirical sense, we do provide a framework for addressing these issues. We develop some new results from the Barberis-Shleifer model which allows us to understand some of the time series properties of style relative price performance and determine the statistical properties of the time until a switch between styles. We apply our results to a set of empirical data to get estimates of some of the model parameters including the level of risk aversion of market participants

A reassessment of the risk-return tradeoff at the daily horizon

This note makes two contributions by extending the analysis in Bali and Peng (2006) which investigates the risk-return tradeoff at the daily horizon using high-frequency data. Our first contribution is to show that the empirical relation between returns and risk is not validated for recent years. Our second contribution is to assess the importance of disentangling jumps from the continuous component using high-frequency data and recent nonparametric methods. We show that similar results are obtained using either realized variance or an alternative measure of realized variance which is robust to jumps thereby providing evidence that jumps do not improve significantly the explanatory power in the risk-return relation.risk-return tradeoff, ICAPM, realized volatility, bipower variation, jumps.

Limit order placement as an utility maximization problem and the origin of power law distribution of limit order prices

I consider the problem of the optimal limit order price of a financial asset in the framework of the maximization of the utility function of the investor. The analytical solution of the problem gives insight on the origin of the recently empirically observed power law distribution of limit order prices. In the framework of the model, the most likely proximate cause of this power law is a power law heterogeneity of traders' investment time horizons .Comment: 7 pages, 2 figure

Risk Aversion and Trade Union Membership

In an open-shop model of trade union membership with heterogeneity in risk attitudes, a worker's relative risk aversion can affect the decision to join a trade union. Furthermore, a shift in risk attitudes can alter collective bargaining outcomes. Using German panel data (GSOEP) and three novel direct measures of individual risk aversion, we find evidence of a significantly positive relationship between risk aversion and the likelihood of union membership. Additionally, we observe a negative correlation between bargained wages in aggregate and average risk preferences of union members. Our results suggest that an overall increase in risk aversion contributes to wage moderation and promotes employment.Employment, membership, risk aversion, trade union

Consumption habits and humps : [Version 23 June 2013]

We show that the optimal consumption of an individual over the life cycle can have the hump shape (inverted U-shape) observed empirically if the preferences of the individual exhibit internal habit formation. In the absence of habit formation, an impatient individual would prefer a decreasing consumption path over life. However, because of habit formation, a high initial consumption would lead to high required consumption in the future. To cover the future required consumption, wealth is set aside, but the necessary amount decreases with age which allows consumption to increase in the early part of life. At some age, the impatience outweighs the habit concerns so that consumption starts to decrease. We derive the optimal consumption strategy in closed form, deduce sufficient conditions for the presence of a consumption hump, and characterize the age at which the hump occurs. Numerical examples illustrate our findings. We show that our model calibrates well to U.S. consumption data from the Consumer Expenditure Survey