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Prospect theory and trading patterns

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  • Yao, Jing
  • Li, Duan
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    Abstract

    Reference dependence, loss aversion, and risk seeking for losses together comprise the preference-based component of prospect theory that sets its value function apart from the standard risk-aversion model. Using an elasticity analysis, we show that this distinctive preference component serves to underpin negative-feedback trading propensities, but cannot manifest itself in behavior directly or holistically at the individual-choice level. We then propose and demonstrate that the market interaction between prospect-theory investors and regular CRRA investors allows this preference component to dominate in equilibrium behavior and hence helps to reestablish the intuitive link between prospect-theory preferences and negative-feedback trading patterns. In the model, the interaction also reconciles the contrarian behavior of prospect-theory investors with asymmetric volatility and short-term return reversal. The results suggest that prospect-theory preferences can lead investors to behave endogenously as contrarian noise traders in the market interaction process.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Banking & Finance.

    Volume (Year): 37 (2013)
    Issue (Month): 8 ()
    Pages: 2793-2805

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    Handle: RePEc:eee:jbfina:v:37:y:2013:i:8:p:2793-2805

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    Web page: http://www.elsevier.com/locate/jbf

    Related research

    Keywords: Prospect theory; Negative-feedback trading; Price elasticity of demand; Contrarian behavior; Disposition effect; Noise trading;

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