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The optimal allocation of risks under prospect theory

Listed author(s):
  • Stracca, Livio

This paper deals with the optimal allocation of risks for an agent whose preferences may be represented with prospect theory (Tversky and Kahneman, 1992). A simple setting is considered with n identically distributed and symmetric sources of risk. Under expected utility, equal diversification of risks is optimal in this setting ('do not put your eggs in the same basket'). Conversely, under prospect theory, provided that the subjective probability of obtaining a perfect hedge is negligible, risk concentration is optimal ('do put your eggs in the same basket'). The intuitive reason behind this result is that a prospect theory agent is risk-seeking over losses, with the consequence that the proerty of diversification of averaging downside risks is welfare-reducing rather than welfare-improving. JEL Classification: D81

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Paper provided by European Central Bank in its series Working Paper Series with number 0161.

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Date of creation: Jul 2002
Handle: RePEc:ecb:ecbwps:20020161
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