Journal of Banking & Finance Vol. 37 No. 8 2013
Prospect theory and trading patterns
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.
- DOI
- 10.1016/j.jbankfin.2013.04.001
- Volume
- 37
- Issue
- 8
- Pages
- 2793-2805
- Language
- en
- Sources
- openalex crossref bibtex:phds-export.bib