Publication:
Linear tests for decreasing absolute risk aversion stochastic dominance

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GRADUATE SCHOOL OF BUSINESS
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Fang, Yi
Kopa, Milos

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We develop and implement linear formulations of convex stochastic dominance relations based on decreasing absolute risk aversion (DARA) for discrete and polyhedral choice sets. Our approach is based on a piecewise-exponential representation of utility and a local linear approximation to the exponentiation of log marginal utility. An empirical application to historical stock market data suggests that a passive stock market portfolio is DARA stochastic dominance inefficient relative to concentrated portfolios of small-cap stocks. The mean-variance rule and Nth-order stochastic dominance rules substantially underestimate the degree of market portfolio inefficiency because they do not penalize the unfavorable skewness of diversified portfolios, in violation of DARA.

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The Institute for Operations Research and the Management Sciences (INFORMS)

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Management, Operations research, Management science

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Management Science

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DOI

10.1287/mnsc.2014.1960

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