Scandinavian Working Papers in Economics

Discussion Papers,
Norwegian School of Economics, Department of Business and Management Science

No 2005/19: Making Prospect Theory Fit for Finance

Enrico De Giorgi () and Thorsten Hens ()
Additional contact information
Enrico De Giorgi: Institute of Finance, University of Lugano, Postal: Institute of Finance , University of Lugano , Via Buffi 13 , CH-6900 Lugano , Switzerland
Thorsten Hens: Institute for Empirical Research in Economics, University of Zurich, Postal: University of Zurich, Institute for Empirical Research in Economics, Bl├╝mlisalpstrasse 10, 8006 Z├╝rich, Switzerland

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

JEL-codes: G00

18 pages, December 22, 2005

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