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Estimating Prospect Theory'S Decision Weights With Stochastic Dominance: The Small Probability Case

Author

Listed:
  • HAIM LEVY

    (The Hebrew University of Jerusalem and The Academic Center of Law and Business, Ramat Gan, 12 Shahar Street Jerusalem, 96263, Israel)

  • MICHAL ORKAN

    (The Hebrew University of Jerusalem, 9 Shmaryahu Levin Street, Kiryat Yuvel, 96664, Jerusalem, Israel)

Abstract

When one prospect is certain and the other uncertain, Cumulative Prospect Theory employs the certainty equivalent methodology to estimate Decision Weights (DW). However, DW may be different with two uncertain prospects. In this study, we neutralize the "certainty effect" and propose Stochastic Dominance (SD) to estimate DW for the first time with small probabilities, which is the raison d'être of the employment of DW. Using SD we provide ranges, rather than point estimates, of DW parameters that are consistent with all possible S-shape value functions. Comparing CE and SD implied DW, we find that DW are situation dependent: DW derived with one certain prospect are much different than those derived with two uncertain prospects.

Suggested Citation

  • Haim Levy & Michal Orkan, 2012. "Estimating Prospect Theory'S Decision Weights With Stochastic Dominance: The Small Probability Case," Annals of Financial Economics (AFE), World Scientific Publishing Co. Pte. Ltd., vol. 7(02), pages 1-27.
    • Handle: RePEc:wsi:afexxx:v:07:y:2012:i:02:n:s2010495212500066
    DOI: 10.1142/S2010495212500066
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    Cited by:

    1. Tai-Yuen Hon & Massoud Moslehpour & Kai-Yin Woo, 2021. "Review on Behavioral Finance with Empirical Evidence," Advances in Decision Sciences, Asia University, Taiwan, vol. 25(4), pages 15-41, December.

    More about this item

    Keywords

    Cumulative prospect theory; expected utility; stochastic dominance; decision weights; S-shape value function; certainty effect; C91; D81;
    All these keywords.

    JEL classification:

    • C91 - Mathematical and Quantitative Methods - - Design of Experiments - - - Laboratory, Individual Behavior
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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