Prospect theory and trading patterns

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review

13 Scopus Citations
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Author(s)

Detail(s)

Original languageEnglish
Pages (from-to)2793-2805
Journal / PublicationJournal of Banking and Finance
Volume37
Issue number8
Online published17 Apr 2013
Publication statusPublished - Aug 2013
Externally publishedYes

Abstract

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.

Research Area(s)

  • Contrarian behavior, Disposition effect, Negative-feedback trading, Noise trading, Price elasticity of demand, Prospect theory

Citation Format(s)

Prospect theory and trading patterns. / Yao, Jing; Li, Duan.

In: Journal of Banking and Finance, Vol. 37, No. 8, 08.2013, p. 2793-2805.

Research output: Journal Publications and Reviews (RGC: 21, 22, 62)21_Publication in refereed journalpeer-review