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Prospect theory and the effectiveness of price limits

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  • Lin, Mei-Chen
  • Chou, Pin-Huang
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    Abstract

    Assuming that traders are risk-neutral, Brennan (1986) shows that price limits are effective in improving the efficiency of futures contracts with limited accessibility to information because they obscure the exact loss when they are triggered. However, Brennan's (1986) model fails to explain why price limits also exist in contracts with abundant information like those of financial futures. We show that when traders are loss-averse, the effectiveness of price limits is strengthened even in the presence of precise information. Thus, our analysis provides a theoretical foundation explaining why price limits can be useful when market participants are not fully rational.

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    Bibliographic Info

    Article provided by Elsevier in its journal Pacific-Basin Finance Journal.

    Volume (Year): 19 (2011)
    Issue (Month): 3 (June)
    Pages: 330-349

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    Handle: RePEc:eee:pacfin:v:19:y:2011:i:3:p:330-349

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

    Related research

    Keywords: Price limits Margin requirement Default risk Loss aversion;

    References

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