On Behavioral Arrow Pratt Risk Process With Applications To Risk Pricing, Stochastic Cash Flows, And Risk Control

The authors introduce a closed form behavioural stochastic Arrow-Pratt risk process, decomposed into discrete asymmetric risk seeking and risk averse components that run on different local times in ?-disks centered at risk free states. Additionally, they embed Arrow-Pratt ("AP") risk measure in a simple dynamic system of discounted cash flows with constant volatility, and time varying drift. Signal extraction of Arrow-Pratt risk measure shows that it is highly nonlinear in constant volatility for cash flows. Robust identifying restrictions on the system solution confirm that even for small time periods constant volatility is not a measure of AP risk.