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Prospect theory and the effectiveness of price limits

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  • Lin, Mei-Chen
  • Chou, Pin-Huang

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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  • Lin, Mei-Chen & Chou, Pin-Huang, 2011. "Prospect theory and the effectiveness of price limits," Pacific-Basin Finance Journal, Elsevier, vol. 19(3), pages 330-349, June.
    • Handle: RePEc:eee:pacfin:v:19:y:2011:i:3:p:330-349
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    References listed on IDEAS

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    Cited by:

    1. Manhwa Wu & Paoyu Huang & Yensen Ni, 2020. "The Impact of Institutional Shareholdings on Price Limits," Asia-Pacific Financial Markets, Springer;Japanese Association of Financial Economics and Engineering, vol. 27(3), pages 343-361, September.
    2. Imtiaz Mohammad Sifat & Azhar Mohamad, 2019. "Circuit breakers as market stability levers: A survey of research, praxis, and challenges," International Journal of Finance & Economics, John Wiley & Sons, Ltd., vol. 24(3), pages 1130-1169, July.
    3. Chu, Shan-Ying & Chan, Lin Kun & Yeh, Jin-Huei, 2019. "The stabilizing effects of price limits: New evidence from jump contributed price variations," The North American Journal of Economics and Finance, Elsevier, vol. 48(C), pages 529-539.
    4. Chen-Yu Chen & Jian-Hsin Chou & Hung-Gay Fung & Yiuman Tse, 2017. "Setting the futures margin with price limits: the case for single-stock futures," Review of Quantitative Finance and Accounting, Springer, vol. 48(1), pages 219-237, January.
    5. Liao, Wen Ju & Sung, Hao-Chang, 2020. "Implied risk aversion and pricing kernel in the FTSE 100 index," The North American Journal of Economics and Finance, Elsevier, vol. 54(C).

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