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

Agustín Shehadi Candela · QUAFI Research · 2026-06-01 · v1.0

Abstract

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 self-contained survey maps the decision-theoretic frontier of that statement — how the field has moved beyond the von Neumann–Morgenstern and Savage expected-utility core in response to the systematic ways real markets break it. It is organized around four breaks: risk attitudes (the Allais paradox and the non-expected-utility families that repair it — rank-dependent, prospect-theoretic, disappointment-averse, reference-dependent); ambiguity (the Ellsberg paradox and maxmin, variational, smooth, and robust-control preferences); time and customs (dynamic inconsistency, recursive utility, and habit formation as the formalization of custom); and frictions (liquidity and asymmetric information, which break the representative, fully-informed agent). The unifying object throughout is the pricing kernel — each behavioral feature or friction is a precise modification of it, judged by the asset-pricing puzzles it resolves, above all the equity-premium puzzle and the Hansen–Jagannathan bound. The paper closes with the open problem that ties the frontier together: the identification of preferences from data. Representation theorems are stated with attribution; elementary derivations are given.

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Cite

@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}
}

Preliminary working paper; circulated for discussion. The views are the author's own. Not investment advice.