A Generalization of Pratt-Arrow Measure to Nonexpected-Utility Preferences and Inseparable Probability and Utility

The Pratt-Arrow measure of local risk aversion is generalized for the n-dimensional state-preference model of choice under uncertainty in which the decision maker may have inseparable probabilities and subjective utilities, unobservable stochastic prior wealth, and/or smooth non-expected-utility preferences. Local risk aversion is measured by the matrix of derivatives of the decision maker’s risk neutral probabilities, without reference to true subjective probabilities or riskless wealth positions, and comparative risk aversion is measured without requiring agreement on true probabilities. Risk neutral probabilities and their derivatives are shown to be sufficient statistics for approximately optimal investment and financing decisions in complete markets for contingent claims. JEL Classification: D810.