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Financial market equilibria with cumulative prospect theory

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  • De Giorgi, Enrico
  • Hens, Thorsten
  • Rieger, Marc Oliver

Abstract

The paper first shows that financial market equilibria need not to exist if agents possess cumulative prospect theory preferences with piecewise-power value functions. This is due to the boundary behavior of the cumulative prospect theory value function, which might cause an infinite short-selling problem. But even when a non-negativity constraint on final wealth is added, non-existence can occur due to the non-convexity of CPT preferences, which might cause discontinuities in the agents' demand functions. This latter observation also implies that concavification arguments which has been used in portfolio allocation problems with CPT preferences do not apply to our general equilibrium setting with finite many agents. Existence of equilibria is established when non-negativity constraints on final wealth are imposed and there is a continuum of agents in the market. However, if the original prospect theory is used instead of cumulative prospect theory, then other discontinuity problems can cause non-existence of market equilibria even in this case.

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Bibliographic Info

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

Volume (Year): 46 (2010)
Issue (Month): 5 (September)
Pages: 633-651

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Handle: RePEc:eee:mateco:v:46:y:2010:i:5:p:633-651

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

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Keywords: Cumulative prospect theory Prospect theory General equilibrium model Non-convex preferences Continuum of agents;

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Cited by:
  1. Li, Yan & Yang, Liyan, 2013. "Prospect theory, the disposition effect, and asset prices," Journal of Financial Economics, Elsevier, Elsevier, vol. 107(3), pages 715-739.
  2. Bernard, Carole & Ghossoub, Mario, 2009. "Static Portfolio Choice under Cumulative Prospect Theory," MPRA Paper 15446, University Library of Munich, Germany.
  3. Matteo Del Vigna, 2011. "Market equilibrium with heterogeneous behavioural and classical investors' preferences," Working Papers - Mathematical Economics, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa 2011-09, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
  4. De Giorgi, Enrico G. & Legg, Shane, 2012. "Dynamic portfolio choice and asset pricing with narrow framing and probability weighting," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 36(7), pages 951-972.
  5. Matteo Del Vigna, 2011. "Financial market equilibria with heterogeneous agents: CAPM and market segmentation," Working Papers - Mathematical Economics, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa 2011-08, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.

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