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Market equilibrium with heterogeneous behavioural and classical investors' preferences

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  • Matteo Del Vigna

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    (Dipartimento di Statistica e Matematica Applicata all'Economia, Universita' di Pisa & CEREMADE , Universite' Paris-Dauphine)

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    Abstract

    Starting from the theory of portfolio selection under Cumulative Prospect Theory (CPT) in a one period model, we firstly present some remarks connected with the violation of the so-called loss aversion in the case of power utility functions. The main contribution of this paper comes from the analysis of two equilibrium models. In the first one, an Expected Utility (EU) maximizer, a CPT agent and an accommodating market maker are allowed to interact. We show that there can be equilibria with null, positive or total risky investment by the CPT trader. Our results are then compared to an analogous model with two EU maximizers. On the contrary, the second financial market is populated by a sufficiently large number of EU agents and CPT agents, each of them being price maker and endowed with possibly heterogeneous preferences, these two facts being new to the literature. This time EU traders fully invest in stocks whereas CPT traders stay out of the risky market. For both models, equilibrium existence and robustness is shown using analytical and numerical methods.

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    Bibliographic Info

    Paper provided by Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa in its series Working Papers - Mathematical Economics with number 2011-09.

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    Length: 39 pages
    Date of creation: Apr 2011
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    Handle: RePEc:flo:wpaper:2011-09

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    Keywords: Cumulative Prospect Theory; equilibrium models; loss aversion; heterogeneous preferences; portfolio optimisation; volatility impact;

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    1. Cuoco, Domenico & Cvitanic, Jaksa, 1998. "Optimal consumption choices for a 'large' investor," Journal of Economic Dynamics and Control, Elsevier, vol. 22(3), pages 401-436, March.
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    5. De Giorgi, Enrico & Hens, Thorsten & Rieger, Marc Oliver, 2010. "Financial market equilibria with cumulative prospect theory," Journal of Mathematical Economics, Elsevier, vol. 46(5), pages 633-651, September.
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    10. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
    11. Nicholas Barberis & Ming Huang, 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices," American Economic Review, American Economic Association, vol. 98(5), pages 2066-2100, December.
    12. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
    13. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February.
    14. Kristoffer Eriksen & Ola Kvaløy, 2010. "Do financial advisors exhibit myopic loss aversion?," Financial Markets and Portfolio Management, Springer, vol. 24(2), pages 159-170, June.
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