Beyond Expected Utility: Decision Theory at the Frontier of Financial Modeling

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Through the no-arbitrage Euler equation, every asset price is a statement about preferences. The price of a payoff is its expectation under a stochastic discount factor built from the marginal utility of the investor who holds it. This survey maps how the field has moved beyond the expected-utility core of von Neumann, Morgenstern and Savage in response to the systematic ways in which real markets and real investors depart from it. The departures are organized into four breaks. The first concerns risk attitudes. The Allais paradox falsifies the independence axiom and motivates rank-dependent, prospect-theoretic, disappointment-averse and reference-dependent utilities, with consequences for the equity premium and for the pricing of skewness. The second concerns ambiguity. The Ellsberg paradox falsifies the existence of a unique subjective prior and motivates Choquet, maxmin, variational and smooth ambiguity preferences, together with robust control. The third concerns time and custom. Discounted utility fails dynamic consistency, which motivates recursive utility and habit formation, the latter being the formalization of custom as a moving standard of consumption. The fourth concerns frictions. Liquidity and asymmetric information break the representative, fully informed agent and dissolve the notion of a single marginal utility. Throughout, the unifying object is the pricing kernel. Each behavioral feature or friction is a precise modification of it, and each is judged by the asset-pricing puzzles it does or does not resolve, above all the equity-premium puzzle and the Hansen–Jagannathan volatility bound. The paper closes with the open problem that ties the frontier together, which is the identification of preferences from data.

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Shehadi Candela, A. (2026). Beyond Expected Utility: Decision Theory at the Frontier of Financial Modeling. QUAFI Working Paper No. 2026-04. QUAFI Research.

@techreport{shehadi2026decision,
  author      = {Shehadi Candela, Agust\'in},
  title       = {Beyond Expected Utility: Decision Theory at the Frontier of Financial Modeling},
  institution = {QUAFI Research},
  type        = {QUAFI Working Paper},
  number      = {2026-04},
  year        = {2026}
}

Historial de versiones

1. v1.113 sep 2026exposition revised throughout; structure and register brought in line with journal practice; no change to results or references
2. v1.01 jun 2026first working-paper draft