Prospect theory and trading patterns
Research output: Journal Publications and Reviews (RGC: 21, 22, 62) › 21_Publication in refereed journal › peer-review
|Journal / Publication||Journal of Banking and Finance|
|Online published||17 Apr 2013|
|Publication status||Published - Aug 2013|
|Link to Scopus||https://www.scopus.com/record/display.uri?eid=2-s2.0-84878651500&origin=recordpage|
Reference dependence, loss aversion, and risk seeking for losses together comprise the preference-based component of prospect theory that sets its value function apart from the standard risk-aversion model. Using an elasticity analysis, we show that this distinctive preference component serves to underpin negative-feedback trading propensities, but cannot manifest itself in behavior directly or holistically at the individual-choice level. We then propose and demonstrate that the market interaction between prospect-theory investors and regular CRRA investors allows this preference component to dominate in equilibrium behavior and hence helps to reestablish the intuitive link between prospect-theory preferences and negative-feedback trading patterns. In the model, the interaction also reconciles the contrarian behavior of prospect-theory investors with asymmetric volatility and short-term return reversal. The results suggest that prospect-theory preferences can lead investors to behave endogenously as contrarian noise traders in the market interaction process.
- Contrarian behavior, Disposition effect, Negative-feedback trading, Noise trading, Price elasticity of demand, Prospect theory