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Prospect theory and hedging risks

  • Broll, Udo
  • Egozcue, Martín
  • Wong, Wing-Keung
  • Zitikis, Ričardas

The prospect theory is one of the most popular decision-making theories. It is based on the S-shaped utility function, unlike the von Neumann and Morgenstern (NM) theory, which is based on the concave utility function. The S-shape brings in mathematical challenges: simple extensions and generalizations of NM theory into the prospect theory cannot be frequently achieved. For example, the nature of monotonicity of the indifference curve depends on the underlying mean. Price hedging decisions also become more complex within the prospect theory. We discuss these topics in detail and offer a general result concerning the sign of a covariance from which we then infer desired properties of the indifference curve and also justify hedging decisions within the prospect theory. We illustrate our general considerations with a thoroughly worked out example.

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Paper provided by Dresden University of Technology, Faculty of Business and Economics, Department of Economics in its series Dresden Discussion Paper Series in Economics with number 05/10.

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Date of creation: 2010
Date of revision:
Handle: RePEc:zbw:tuddps:0510
Contact details of provider: Postal: 01062 Dresden
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  1. Rubinstein, Mark E, 1973. "A Comparative Statics Analysis of Risk Premiums," The Journal of Business, University of Chicago Press, vol. 46(4), pages 605-15, October.
  2. Kawai, Masahiro & Zilcha, Itzhak, 1986. "International trade with forward-futures markets under exchange rate and price uncertainty," Journal of International Economics, Elsevier, vol. 20(1-2), pages 83-98, February.
  3. Meyer, Jack, 1987. "Two-moment Decision Models and Expected Utility Maximization," American Economic Review, American Economic Association, vol. 77(3), pages 421-30, June.
  4. Kit Pong Wong, 2007. "Optimal Export And Hedging Decisions When Forward Markets Are Incomplete," Bulletin of Economic Research, Wiley Blackwell, vol. 59(1), pages 67-81, 01.
  5. Milton Friedman & L. J. Savage, 1948. "The Utility Analysis of Choices Involving Risk," Journal of Political Economy, University of Chicago Press, vol. 56, pages 279.
  6. Markowitz, Harry M, 1991. " Foundations of Portfolio Theory," Journal of Finance, American Finance Association, vol. 46(2), pages 469-77, June.
  7. Sinn, Hans-Werner, 1990. " Expected Utility, mu-sigma Preferences, and Linear Distribution Classes: A Further Result," Journal of Risk and Uncertainty, Springer, vol. 3(3), pages 277-81, September.
  8. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  9. Harry Markowitz, 1952. "The Utility of Wealth," Journal of Political Economy, University of Chicago Press, vol. 60, pages 151.
  10. Enrico Giorgi & Thorsten Hens, 2006. "Making prospect theory fit for finance," Financial Markets and Portfolio Management, Springer, vol. 20(3), pages 339-360, September.
  11. Sandmo, Agnar, 1971. "On the Theory of the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 61(1), pages 65-73, March.
  12. repec:tpr:qjecon:v:94:y:1980:i:2:p:317-28 is not listed on IDEAS
  13. Holthausen, Duncan M, 1979. "Hedging and the Competitive Firm under Price Uncertainty," American Economic Review, American Economic Association, vol. 69(5), pages 989-95, December.
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