Iterated Expectations under Cumulative Prospect Theory: an Impossibility Result
AbstractUnder expected utility theory, compound lotteries can be valued by "iterating" expectations: the expected utility of a compound lottery is the expected value of a simple lottery over prizes that are certainty equivalents to follow-up lotteries. We derive necessary and sufficient conditions for a similar valuation technique in the framework of Cumulative Prospect Theory (CPT) when a decision maker has to choose between prospects that belong to a comonotonic class. Our conditions characterize the compatibility of a prominent alternative to expected utility with valuation methods that are commonly used in applied economics and finance, e.g. in binomial option pricing. The conditions can be viewed as an impossibility result.
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Bibliographic InfoPaper provided by Queen's University, Department of Economics in its series Working Papers with number 1228.
Length: 20 pages
Date of creation: May 2014
Date of revision:
Cumulative Prospect Theory; probability weighting function; conditioning; updating; dynamic consistency; model consistency; consequentialism; valuation methods; Iterated expectations;
Find related papers by JEL classification:
- D80 - Microeconomics - - Information, Knowledge, and Uncertainty - - - General
- D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
This paper has been announced in the following NEP Reports:
- NEP-ALL-2010-02-13 (All new papers)
- NEP-CBE-2010-02-13 (Cognitive & Behavioural Economics)
- NEP-NEU-2010-02-13 (Neuroeconomics)
- NEP-UPT-2010-02-13 (Utility Models & Prospect Theory)
Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
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