Reference Dependent Utility and the Simple Portfolio Problem

Yehuda Izhakian and Jaime Zender

Abstract

How do risk-and ambiguity-averse investors allocate capital between uncertain and uncertaintyfree securities? What are the asset pricing implications of this behavior? We use Izhakian's (2017) model to provide an axiomatic foundation for constructing, from the uncertainty over probabilities in the market and investor preferences, the exogenous nonadditive capacities utilized in Schmeidler (1989) or Wakker and Tversky (1993). This allows an examination of the distinct impacts of ambiguity, ambiguity aversion, risk, and risk aversion on portfolio choice, the allocation of uncertainty across investors and a characterization of the uncertainty premium.