MICRO/THEORY: Source Recursive Utility with Lab and Field Evidence relating to Home Bias; Professor CHEW Soo Hong (National University of Singapore)

Abstract

This talk is based on two related papers:

Rich Mixture Set, Process Preference, And Home Bias

Decision making often involves compounding of risks from different sources. Building on the Herstein-Milnor mixture set axiomatization of expected utility theory, we employ multiple mixture operators each modeling a source of risk to arrive at the definition of a rich mixture set, elements of which are rich lotteries. Our modeling framework enables a source-dependent weakening of the independence axiom as well as the reduction of compound lottery axiom. This yields a representation for preference over rich lotteries called source recursive expected utility (SREU). When there is consistent preference for the “same” lottery arising from different sources, SREU implies a preference for risk being resolved more decisively by the preferred source. We further show that an SREU investor always exhibits home bias when she consistently prefers risks arising from the domestic stock market over identically distributed risks from the foreign stock market.

Click here to view paper.

Experimental Evidence Of Source Preference: Home Bias Explained By Familiarity, Not Ambiguity

This paper experimentally tests the Fox-Tversky (1995) source preference hypothesis as axiomatized in Chew and Sagi (2008) where people may have preference between equally distributed risks depending on the underlying sources of uncertainty. We study two forms of source preference. One is based on familiarity of risks arising from the trailing digit of stock prices in the home city exchange. Another is based on the trailing digit of the market index of the home city versus that of a foreign city. We find a familiarity-based source preference in portfolios comprising strictly dominated bets associated with more familiar stocks and in valuation of bets elicited using an ascending-price auction. Complementarily, we find a home bias in terms of Shanghai (Hong Kong) subjects preferring to bet on the trailing digit of the Shanghai Stock Exchange Index (Hang Seng Index) even though the same bets based on Dow Jones Industrial Average would pay more. Taken together, our study suggests that home bias is driven mainly by source preference rather than ambiguity aversion.

Click here to view paper.