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Making prospect theory fit for finance

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Author Info

  • Enrico Giorgi

    ()

  • Thorsten Hens

    ()

Abstract

This paper gives a survey over a common aspect of prospect theory that occurred to be of importance in a series of recent papers developed by Enrico De Giorgi, Thorsten Hens, Janos Mayer, Haim Levy, Thierry Post, Marc Oliver Rieger and Mei Wang. The common aspect of these papers is that the value function of the prospect theory of Kahneman and Tversky (1979) and similarly that of Tversky and Kahneman (1992) has to be re-modelled if one wants to apply it to portfolio selection. Instead of the piecewise power value function, a piecewise negative exponential function should be used. This functional form is still compatible with laboratory experiments but it has the following advantages over and above Kahneman and Tversky`s piecewise power function: 1. The Bernoulli Paradox does not arise for lotteries with finite expected value. 2. No infinite leverage/robustness problem arises. 3. CAPM-equilibria with heterogeneous investors and prospect utility do exist. 4. It is able to simultaneously resolve the following asset pricing puzzles: the equity premium, the value and the size puzzle.

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File URL: http://hdl.handle.net/10.1007/s11408-006-0019-1
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Bibliographic Info

Article provided by Springer in its journal Financial Markets and Portfolio Management.

Volume (Year): 20 (2006)
Issue (Month): 3 (September)
Pages: 339-360

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Handle: RePEc:kap:fmktpm:v:20:y:2006:i:3:p:339-360

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Web page: http://www.springerlink.com/link.asp?id=119763

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Keywords: D 01; D 14; D 81; G 11;

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References

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  1. Samuelson, Paul A, 1969. "Lifetime Portfolio Selection by Dynamic Stochastic Programming," The Review of Economics and Statistics, MIT Press, vol. 51(3), pages 239-46, August.
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  8. Hens, Thorsten & Vlcek, Martin, 2005. "Does Prospect Theory Explain the Disposition Effect?," Discussion Papers 2005/18, Department of Business and Management Science, Norwegian School of Economics.
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  12. Amos Tversky & Daniel Kahneman, 1979. "Prospect Theory: An Analysis of Decision under Risk," Levine's Working Paper Archive 7656, David K. Levine.
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  18. Nicholas Barberis & Wei Xiong, 2009. "What Drives the Disposition Effect? An Analysis of a Long-Standing Preference-Based Explanation," Journal of Finance, American Finance Association, vol. 64(2), pages 751-784, 04.
  19. Weber, Martin & Camerer, Colin F., 1998. "The disposition effect in securities trading: an experimental analysis," Journal of Economic Behavior & Organization, Elsevier, vol. 33(2), pages 167-184, January.
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  23. Enrico Giorgi & Thorsten Hens & János Mayer, 2007. "Computational aspects of prospect theory with asset pricing applications," Computational Economics, Society for Computational Economics, vol. 29(3), pages 267-281, May.
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Citations

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Cited by:
  1. Peel, D.A., 2010. "On lottery sales, jackpot sizes and irrationality: A cautionary note," Economics Letters, Elsevier, vol. 109(3), pages 161-163, December.
  2. Carole Bernard & Jit Seng Chen & Steven Vanduffel, 2013. "Rationalizing Investors Choice," Papers 1302.4679, arXiv.org, revised Jan 2014.
  3. Liu, Shuangzhe & Ma, Tiefeng & Polasek, Wolfgang, 2012. "Spatial System Estimators for Panel Models: A Sensitivity and Simulation Study," Economics Series 294, Institute for Advanced Studies.
  4. Marie-Hélène Broihanne & Maxime Merli & Patrick Roger, 2008. "A Behavioural Approach To Financial Puzzles," Working Papers of LaRGE Research Center 2008-01, Laboratoire de Recherche en Gestion et Economie (LaRGE), Université de Strasbourg.
  5. André Gygax & Anna Griffiths, 2007. "Do venture capitalists imitate portfolio size?," Financial Markets and Portfolio Management, Springer, vol. 21(1), pages 69-94, March.
  6. Fortin, Ines & Hlouskova, Jaroslava, 2011. "Optimal asset allocation under linear loss aversion," Journal of Banking & Finance, Elsevier, vol. 35(11), pages 2974-2990, November.
  7. repec:ebl:ecbull:v:4:y:2007:i:26:p:1-10 is not listed on IDEAS
  8. Broll, Udo & Egozcue, Martín & Wong, Wing-Keung & Zitikis, Ričardas, 2010. "Prospect theory and hedging risks," Dresden Discussion Paper Series in Economics 05/10, Dresden University of Technology, Faculty of Business and Economics, Department of Economics.
  9. Peel, D.A. & Zhang, Jie, 2012. "On the potential for observational equivalence in experiments on risky choice when a power value function is assumed," Economics Letters, Elsevier, vol. 116(1), pages 8-10.
  10. Marie Pfiffelmann, 2006. "Which Optimal Design For LLDAs?," Working Papers of LaRGE Research Center 2006-06, Laboratoire de Recherche en Gestion et Economie (LaRGE), Université de Strasbourg.
  11. Bernard, Carole & Ghossoub, Mario, 2009. "Static Portfolio Choice under Cumulative Prospect Theory," MPRA Paper 15446, University Library of Munich, Germany.
  12. Azevedo, Eduardo M. & Gottlieb, Daniel, 2012. "Risk-neutral firms can extract unbounded profits from consumers with prospect theory preferences," Journal of Economic Theory, Elsevier, vol. 147(3), pages 1291-1299.
  13. Fortin, Ines & Hlouskova, Jaroslava, 2012. "Optimal Asset Allocation under Quadratic Loss Aversion," Economics Series 291, Institute for Advanced Studies.
  14. David Peel & David Law, 2007. "Betting on odds on Favorites as an Optimal Choice in Cumulative Prospect Theory," Economics Bulletin, AccessEcon, vol. 4(26), pages 1-10.
  15. Marie Pfiffelmann, 2011. "Solving the St. Petersburg Paradox in cumulative prospect theory: the right amount of probability weighting," Theory and Decision, Springer, vol. 71(3), pages 325-341, September.
  16. Peel, D.A. & Zhang, Jie, 2009. "The expo-power value function as a candidate for the work-horse specification in parametric versions of cumulative prospect theory," Economics Letters, Elsevier, vol. 105(3), pages 326-329, December.
  17. Trond Døskeland, 2007. "Strategic asset allocation for a country: the Norwegian case," Financial Markets and Portfolio Management, Springer, vol. 21(2), pages 167-201, June.

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