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Prospect theory, the disposition effect, and asset prices

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  • Li, Yan
  • Yang, Liyan
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    Abstract

    We build a general equilibrium model to examine the implications of prospect theory for the disposition effect, asset prices, and trading volume. Diminishing sensitivity predicts a disposition effect, price momentum, a reduced return volatility, and a positive return-volume correlation. Loss aversion generally predicts the opposite. In calibrated economies, there is a nontrivial range of preference parameters for prospect theory to simultaneously explain the disposition effect, the momentum effect, and the equity premium puzzle. Our model is helpful for understanding a wide range of financial phenomena and it also suggests new testable predictions.

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    Bibliographic Info

    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 107 (2013)
    Issue (Month): 3 ()
    Pages: 715-739

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    Handle: RePEc:eee:jfinec:v:107:y:2013:i:3:p:715-739

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    Web page: http://www.elsevier.com/locate/inca/505576

    Related research

    Keywords: Prospect theory; Disposition effect; Momentum; Reversal; Turnover;

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    Cited by:
    1. Kohsaka Youki & Grzegorz Mardyla & Shinji Takenaka & Yoshiro Tsutsui, 2013. "Disposition Effect and Diminishing Sensitivity: An Analysis Based on a Simulated Experimental Stock Market," Discussion Papers in Economics and Business 13-02-Rev, Osaka University, Graduate School of Economics and Osaka School of International Public Policy (OSIPP), revised Dec 2013.
    2. Allen, Franklin & Vayanos, Dimitri & Vives, Xavier, 2014. "Introduction to financial economics," Journal of Economic Theory, Elsevier, vol. 149(C), pages 1-14.
    3. Pasquariello, Paolo, 2014. "Prospect Theory and market quality," Journal of Economic Theory, Elsevier, vol. 149(C), pages 276-310.

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