Utility theory front to back - inferring utility from agents' choices

Abstract: We pursue an inverse approach to utility theory and consumption & investment problems. Instead of specifying an agent's utility function and deriving her actions, we assume we observe her actions (i.e. her consumption and investment strategies) and ask if it is possible to derive a utility function for which the observed behaviour is optimal. We work in continuous time both in a deterministic and stochastic setting. In the deterministic setup, we find that there are infinitely many utility functions generating a given consumption pattern. In the stochastic setting of the Black-Scholes complete market it turns out that the consumption and investment strategies have to satisfy a consistency condition (PDE) if they are to come from a classical utility maximisation problem. We show further that important characteristics of the agent such as her attitude towards risk (e.g. DARA) can be deduced directly from her consumption/investment choices.