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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.

Suggested Citation

  • 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.
  • Handle: RePEc:eee:mateco:v:46:y:2010:i:5:p:633-651
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    References listed on IDEAS

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    Cited by:

    1. Curatola, Giuliano, 2015. "Loss aversion, habit formation and the term structures of equity and interest rates," Journal of Economic Dynamics and Control, Elsevier, vol. 53(C), pages 103-122.
    2. 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, vol. 36(7), pages 951-972.
    3. Matteo Del Vigna, 2011. "Market equilibrium with heterogeneous behavioural and classical investors' preferences," Working Papers - Mathematical Economics 2011-09, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    4. Dorsaf Ben Aissia, 2016. "Developments in non-expected utility theories: an empirical study of risk aversion," Journal of Economics and Finance, Springer;Academy of Economics and Finance, vol. 40(2), pages 299-318, April.
    5. repec:wsi:qjfxxx:v:07:y:2017:i:02:n:s201013921750001x is not listed on IDEAS
    6. Matteo Del Vigna, 2011. "Financial market equilibria with heterogeneous agents: CAPM and market segmentation," Working Papers - Mathematical Economics 2011-08, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    7. Guo, Jing & He, Xue Dong, 2017. "Equilibrium asset pricing with Epstein-Zin and loss-averse investors," Journal of Economic Dynamics and Control, Elsevier, vol. 76(C), pages 86-108.
    8. repec:eee:econom:v:198:y:2017:i:2:p:253-270 is not listed on IDEAS
    9. Toomas Hinnosaar, 2015. "On the impossibility of protecting risk-takers," Carlo Alberto Notebooks 404, Collegio Carlo Alberto.
    10. Vicky Henderson, 2012. "Prospect Theory, Liquidation, and the Disposition Effect," Management Science, INFORMS, vol. 58(2), pages 445-460, February.
    11. Bernard, Carole & Ghossoub, Mario, 2009. "Static Portfolio Choice under Cumulative Prospect Theory," MPRA Paper 15446, University Library of Munich, Germany.
    12. Li, Yan & Yang, Liyan, 2013. "Prospect theory, the disposition effect, and asset prices," Journal of Financial Economics, Elsevier, vol. 107(3), pages 715-739.

    More about this item

    Keywords

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

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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