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Stochastic Dominance and Cumulative Prospect Theory

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  • Baucells Alibés Manel

    () (UNIVERSITY OF NAVARRA)

  • Heukamp Franz H.

    () (UNIVERSIDAD DE NAVARRA)

Abstract

We generalize and extend the second order stochastic dominance condition available for Expected Utility to Cumulative Prospect Theory. The new definitions include, among others, preferences represented by S-shaped value and inverse S-shaped probability weighting functions. The stochastic dominance conditions supply a framework to test different features of Cumulative Prospect Theory. In the experimental part of the working paper we offer a test of several joint hypotheses on the value function and the probability weighting function. Assuming empirically relevant weighting functions, we can reject the inverse S-shaped value function recently advocated by Levy and Levy (2002a), in favor of the S-shaped form. In addition, we find generally supporting evidence for loss aversion. Violations of loss aversion can be linked to subjects using the overall probability of winning as heuristic.

Suggested Citation

  • Baucells Alibés Manel & Heukamp Franz H., 2007. "Stochastic Dominance and Cumulative Prospect Theory," Working Papers 201061, Fundacion BBVA / BBVA Foundation.
  • Handle: RePEc:fbb:wpaper:201061
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    References listed on IDEAS

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    Citations

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    Cited by:

    1. Guo, Dongmei & Hu, Yi & Wang, Shouyang & Zhao, Lin, 2016. "Comparing risks with reference points: A stochastic dominance approach," Insurance: Mathematics and Economics, Elsevier, vol. 70(C), pages 105-116.
    2. Fong, Wai Mun, 2016. "Stochastic dominance and the omega ratio," Finance Research Letters, Elsevier, vol. 17(C), pages 7-9.
    3. Baucells, Manel & Heukamp, Franz H., 2004. "Reevaluation of the results of Levy and Levy (2002a)," Organizational Behavior and Human Decision Processes, Elsevier, vol. 94(1), pages 15-21, May.
    4. Stefan T. Trautmann & Ferdinand M. Vieider & Peter P. Wakker, 2011. "Preference Reversals for Ambiguity Aversion," Management Science, INFORMS, vol. 57(7), pages 1320-1333, July.
    5. Stelios Arvanitis & Nikolas Topaloglou, 2015. "Consistent tests for risk seeking behavior: A stochastic dominance approach Abstract We develop non-parametric tests for prospect stochastic dominance Efficiency (PSDE) and Markowitz stochastic domina," Working Papers 201511, Athens University Of Economics and Business, Department of Economics.
    6. Sergio Ortobelli & Svetlozar Rachev & Haim Shalit & Frank Fabozzi, 2009. "Orderings and Probability Functionals Consistent with Preferences," Applied Mathematical Finance, Taylor & Francis Journals, vol. 16(1), pages 81-102.
    7. Baucells, Manel & Rata, Cristina, 2004. "Framing and stakes: A survey study of decisions under uncertainty," IESE Research Papers D/568, IESE Business School.
    8. Matteo Del Vigna, 2012. "Stochastic dominance for law invariant preferences: The happy story of elliptical distributions," Working Papers - Mathematical Economics 2012-08, Universita' degli Studi di Firenze, Dipartimento di Scienze per l'Economia e l'Impresa.
    9. repec:eee:econom:v:198:y:2017:i:2:p:253-270 is not listed on IDEAS
    10. Bernard, Carole & Chen, Jit Seng & Vanduffel, Steven, 2015. "Rationalizing investors’ choices," Journal of Mathematical Economics, Elsevier, vol. 59(C), pages 10-23.
    11. Peter Brooks & Simon Peters & Horst Zank, 2014. "Risk behavior for gain, loss, and mixed prospects," Theory and Decision, Springer, pages 153-182.
    12. Ulrich Schmidt & Chris Starmer & Robert Sugden, 2008. "Third-generation prospect theory," Journal of Risk and Uncertainty, Springer, vol. 36(3), pages 203-223, June.
    13. George Wu & Alex B. Markle, 2008. "An Empirical Test of Gain-Loss Separability in Prospect Theory," Management Science, INFORMS, vol. 54(7), pages 1322-1335, July.
    14. Stoyanov, Stoyan V. & Rachev, Svetlozar T. & Fabozzi, Frank J., 2009. "Construction of probability metrics on classes of investors," Economics Letters, Elsevier, vol. 103(1), pages 45-48, April.
    15. Bernard, Carole & Ghossoub, Mario, 2009. "Static Portfolio Choice under Cumulative Prospect Theory," MPRA Paper 15446, University Library of Munich, Germany.
    16. Fang, Yi, 2012. "Aggregate investor preferences and beliefs in stock market: A stochastic dominance analysis," Journal of Empirical Finance, Elsevier, vol. 19(4), pages 528-547.

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