Discussion Papers, Department of Business and Management Science, Norwegian School of Economics (NHH)
Enrico De Giorgi
Making Prospect Theory Fit for Finance
() and Thorsten Hens
Abstract: This paper gives a survey over a common aspect of prospect
theory that occurred to be of importance in a series of recent papers
developed by Enrico De Giorgi, Thorsten Hens, Janos Mayer, Haim Levy,
Thierry Post, Marc Oliver Rieger and Mei Wang. The common aspect of these
papers is that the value function of the prospect theory of Kahneman and
Tversky (1979) and similarly that of Tversky and Kahneman (1992) has to be
re-modelled if one wants to apply it to portfolio selection. Instead of the
piecewise power value function, a piecewise negative exponential function
should be used. This functional form is still compatible with laboratory
experiments but it has the following advantages over and above Kahneman and
Tversky`s piecewise power function:
1. The Bernoulli Paradox does not
arise for lotteries with finite expected value.
2. No infinite
leverage/robustness problem arises.
3. CAPM-equilibria with
heterogeneous investors and prospect utility do exist.
4. It is able to
simultaneously resolve the following asset pricing puzzles: the equity
premium, the value and the size puzzle.
Keywords: Prospect theory; portfolio selection; (follow links to similar papers)
JEL-Codes: G00; (follow links to similar papers)
18 pages, December 22, 2005
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