Optimizing S-shaped utility and implications for risk management

TL;DR

This paper examines how traditional risk measures like VaR and ES are ineffective against tail-risk-seeking investors with S-shaped utility, and proposes alternative constraints to mitigate unbounded risk-taking.

Contribution

It demonstrates that standard risk measures do not constrain S-shaped utility maximization and introduces utility-based constraints as a more effective risk management approach.

Findings

VaR and ES do not limit tail-risk-seeking behavior in standard models.

Conventional concave utility constraints can reduce maximal S-shaped utility.

Unbounded S-shaped utilities lead to unbounded negative utility under constraints.

Abstract

We consider market players with tail-risk-seeking behaviour as exemplified by the S-shaped utility introduced by Kahneman and Tversky. We argue that risk measures such as value at risk (VaR) and expected shortfall (ES) are ineffective in constraining such players. We show that, in many standard market models, product design aimed at utility maximization is not constrained at all by VaR or ES bounds: the maximized utility corresponding to the optimal payoff is the same with or without ES constraints. By contrast we show that, in reasonable markets, risk management constraints based on a second more conventional concave utility function can reduce the maximum S-shaped utility that can be achieved by the investor, even if the constraining utility function is only rather modestly concave. It follows that product designs leading to unbounded S-shaped utilities will lead to unbounded negative expected constraining utilities when measured with such conventional utility functions. To prove these latter results we solve a general problem of optimizing an investor expected utility under risk management constraints where both investor and risk manager have conventional concave utility functions, but the investor has limited liability. We illustrate our results throughout with the example of the Black--Scholes option market. These results are particularly important given the historical role of VaR and that ES was endorsed by the Basel committee in 2012--2013.