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Prospect theory and hedging risks

Author

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

Abstract

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.

Suggested Citation

  • Broll, Udo & Egozcue, Martín & Wong, Wing-Keung & Zitikis, Ričardas, 2010. "Prospect theory and hedging risks," Dresden Discussion Paper Series in Economics 05/10, Technische Universität Dresden, Faculty of Business and Economics, Department of Economics.
    • Handle: RePEc:zbw:tuddps:0510
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    References listed on IDEAS

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    More about this item

    Keywords

    prospect theory; mean-variance model; indifference curve; price uncertainty; hedging;
    All these keywords.

    JEL classification:

    • D01 - Microeconomics - - General - - - Microeconomic Behavior: Underlying Principles
    • D03 - Microeconomics - - General - - - Behavioral Microeconomics: Underlying Principles
    • D21 - Microeconomics - - Production and Organizations - - - Firm Behavior: Theory
    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty

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