An Axiomatization of Linear Cumulative Prospect Theory with Applications to Portfolio Selection and Insurance Demand
The present paper combines loss attitudes and linear utility by providing an axiomatic analysis of corresponding preferences in a cumulative prospect theory (CPT) framework. CPT is one of the most promising alternatives to expected utility theory since it incorporates loss aversion, and linear utility for money receives increasing attention since it is often concluded in empirical research, and employed in theoretical applications. Rabin (2000) emphasizes the importance of linear utility, and highlights loss aversion as an explanatory feature for the disparity of significant small-scale risk aversion and reasonable large-scale risk aversion. In a sense we derive a two-sided variant of Yaari s dual theory, i.e. nonlinear probability weights in the presence of linear utility. The first important difference is that utility may have a kink at the status quo, which allows for the exhibition of loss aversion. Also, we may have different probability weighting functions for gains than for losses. The central condition of our model is termed independence of common increments. The applications of our model to portfolio selection and insurance demand show that CPT with linear utility has more realistic implications than the dual theory since it implies only a weakened variant of plunging.
|Date of creation:||29 Aug 2002|
|Contact details of provider:|| Postal: Office of the Secretary-General, Rm E35, The Bute Building, Westburn Lane, St Andrews, KY16 9TS, UK|
Phone: +44 1334 462479
Web page: http://www.res.org.uk/society/annualconf.asp
More information through EDIRC
When requesting a correction, please mention this item's handle: RePEc:ecj:ac2002:161. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (Christopher F. Baum)
If references are entirely missing, you can add them using this form.