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Portfolio Choice Under Cumulative Prospect Theory: An Analytical Treatment

  • Xue Dong He


    (Industrial Engineering and Operations Research Department, Columbia University, New York, New York 10027)

  • Xun Yu Zhou


    (Nomura Centre for Mathematical Finance, University of Oxford, Oxford OX1 3LB, United Kingdom; Oxford-Man Institute of Quantitative Finance, University of Oxford, Oxford OX2 6ED, United Kingdom; and Department of Systems Engineering and Engineering Management, Chinese University of Hong Kong, Shatin, Hong Kong)

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    We formulate and carry out an analytical treatment of a single-period portfolio choice model featuring a reference point in wealth, S-shaped utility (value) functions with loss aversion, and probability weighting under Kahneman and Tversky's cumulative prospect theory (CPT). We introduce a new measure of loss aversion for large payoffs, called the large-loss aversion degree (LLAD), and show that it is a critical determinant of the well-posedness of the model. The sensitivity of the CPT value function with respect to the stock allocation is then investigated, which, as a by-product, demonstrates that this function is neither concave nor convex. We finally derive optimal solutions explicitly for the cases in which the reference point is the risk-free return and those in which it is not (while the utility function is piecewise linear), and we employ these results to investigate comparative statics of optimal risky exposures with respect to the reference point, the LLAD, and the curvature of the probability weighting. This paper was accepted by Wei Xiong, finance.

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    Article provided by INFORMS in its journal Management Science.

    Volume (Year): 57 (2011)
    Issue (Month): 2 (February)
    Pages: 315-331

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    Handle: RePEc:inm:ormnsc:v:57:y:2011:i:2:p:315-331
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