Two New Department Working Papers from Jeffrey Racine and Bradley Ruffle

Our faculty have been busy at work this summer with two new department working papers!

Financial Risk Under Shortfall Level Uncertainty

Jeffrey Racine is a Professor for the Department of Economics. He occupies the Senator William McMaster Chair in Econometrics and is a Fellow of the Journal of Econometrics. His research focus is in Econometrics and Statistics.

Working paper titled, “Financial Risk Under Shortfall Level Uncertainty,” with Assistant Professor at Northern Michigan University, Majid Asadi, Professor Emeritus from University of Milwaukee Michigan, Ehsan S. Soof, and Professor at the University of Kent, Shaomin Wu.

Abstract

We propose a unified approach for developing financial risk measures that are tailored to decision making in the face of two sources of uncertainty, namely, market-based and prudence-based. Common risk measures, including Value at Risk (VaR), Expected Shortfall (ES), and their extensions, are typically assessed at a fixed quantile of the risk variable’s probability distribution, given a prudence level p, thereby only considering market-based uncertainty. We advocate for risk assessment measures that incorporate both sources of uncertainty using a novel decomposition which we present as a representation theorem. Our representation theorem introduces a Mean-Covariance (MCov) decomposition of co-monotonically additive and coherent risk measures, expressed through the expected value of an investment and a covariance functional. Among these market-based uncertainty risk measures, ES has become the dominant measure used in financial decision analysis. We define a Bayesian risk measure as the expected value of ES, incorporating a variable prudence level governed by a prior probability distribution. Within a decision-theoretic framework, this Bayes Expected Shortfall (BES) serves as the optimal shortfall forecast under quadratic loss, termed the prior Bayes estimate. BES has a MCov decomposition where the covariance functional is determined by the prior distribution and is characterized by the properties given by the representation theorem. Specific prudence level distributions yield some premium principles in the existing literature. We explore both parametric and nonparametric methods for its estimation.

Cheating on a Budget

Bradley Ruffle is a Professor for the Department of Economics, as well as the Academic Director for the McMaster Decision Science Laboratory (McDSL). His research focus’ on behavioural and experimental economics.

His working paper is titled, “Cheating on a Budget” with William B. Zhang, current Finance PhD student at UC Berkley .

Abstract

Social dilemmas with a shared resource pool and privately observed entitlements are susceptible to overclaiming. A dishonest claim that exceeds one’s true entitlement imposes a negative externality on others. To explore such social dilemmas, we introduce a novel four-player game where each player rolls a die in private and earns their die report, subject to budget availability. We vary the timing of players’ reporting (simultaneous vs sequential moves) and the available budget (limited vs excess). When resources are limited, mean reports do not differ significantly between simultaneous and sequential treatments. However, simultaneous reporting promotes greater equity under scarcity and reduces dishonesty when resources are plentiful. Frequent displays of virtue signalling take place whereby Player 4 chooses to earn zero by reporting more than the remaining budget. Our results demonstrate that these social dilemmas can be better managed by promoting simultaneous reporting structures, which obscure in formation about individual claims.

For the full set of working papers, visit RePEC/ideas.