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The optimal allocation of risks under prospect theory


  • 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

Suggested Citation

  • Stracca, Livio, 2002. "The optimal allocation of risks under prospect theory," Working Paper Series 0161, European Central Bank.
  • Handle: RePEc:ecb:ecbwps:20020161

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    References listed on IDEAS

    1. Mark Hallerberg & Jürgen von Hagen, 1999. "Electoral Institutions, Cabinet Negotiations, and Budget Deficits in the European Union," NBER Chapters,in: Fiscal Institutions and Fiscal Performance, pages 209-232 National Bureau of Economic Research, Inc.
    2. Lemmen, J.J.G. & Eijffinger, S.C.W., 1995. "The fundamental determinants of financial integration in the European Union," Discussion Paper 1995-117, Tilburg University, Center for Economic Research.
    3. Jan J.G. Lemmen, 1998. "Integrating Financial Markets in the European Union," Books, Edward Elgar Publishing, number 1399.
    4. Dani Rodrik, 1998. "Why Do More Open Economies Have Bigger Governments?," Journal of Political Economy, University of Chicago Press, vol. 106(5), pages 997-1032, October.
    5. Réjane Hugounenq & Jacques Le Cacheux & Thierry Madiès, 1999. "Diversité des fiscalités européennes et risques de concurrence fiscale," Revue de l'OFCE, Programme National Persée, vol. 70(1), pages 63-109.
    6. Signe Krogstrup, 2003. "Are Capital Taxes Racing to the Bottom in the European Union?," IHEID Working Papers 01-2003, Economics Section, The Graduate Institute of International Studies.
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    Cited by:

    1. Sureth, Caren & Voß, Armin, 2005. "Investitionsbereitschaft und zeitliche Indifferenz bei Realinvestitionen unter Unsicherheit und Steuern," arqus Discussion Papers in Quantitative Tax Research 2, arqus - Arbeitskreis Quantitative Steuerlehre.
    2. Magi, Alessandro, 2009. "Portfolio choice, behavioral preferences and equity home bias," The Quarterly Review of Economics and Finance, Elsevier, vol. 49(2), pages 501-520, May.

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    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty


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