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Prospect theory and the effectiveness of price limits

  • Lin, Mei-Chen
  • Chou, Pin-Huang
Registered author(s):

    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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    Article provided by Elsevier in its journal Pacific-Basin Finance Journal.

    Volume (Year): 19 (2011)
    Issue (Month): 3 (June)
    Pages: 330-349

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    Handle: RePEc:eee:pacfin:v:19:y:2011:i:3:p:330-349
    Contact details of provider: Web page: http://www.elsevier.com/locate/pacfin

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