TITLE

Research papers on Prospect Theory

Sherin Alex(A47) and Tarun Kumar(A28)
MBA FINANCE

PROSPECT
THEORY
Submitted to: Dr Ruchi Arora
 RESEARCH PAPER 1
Prospect theory for continuous distributions
Marc Oliver Rieger
Mei Wang

Objectives: -
The purpose of this paper is two-fold: on the one hand, we want to generalize PT to non-
discrete outcomes and on the other hand, we want to show how by incorporating a central
editing rule, the collecting of nearby outcomes (Kahneman and Tversky 1979), into PT, the
theory can be made continuous.

Research Methodology: –
for extending PT to non-discrete outcome distributions: our central idea is here to use an
approximation method. More precisely, we approximate non-discrete outcome distributions by
finite lotteries. If we do this in Karmarkar’s formulation (1), we can pass to the limit and obtain
a well-defined expression for the non-discrete outcome distribution.
In the simplest case of a continuous outcome distribution given by the probability density p
and a probability weighting function w defined as in Eq.2 we obtain with this method

After extending PT to arbitrary outcome distribution, we try to solve the problem of continuity:
a small change of a lottery (e.g. splitting a single outcome into two similar outcomes) changes
the PT-value often substantially.

Conclusion: -
We have extended prospect theory for the evaluation of non-discrete outcome distributions,
while still preserving the positive features of PT. This extension is therefore more consistent
with some of the patterns observed in experiments than CPT, although it does not require more
fitting parameters. The continuous limit is even to some extent independent of the precise
choice of the weighting function which brings a substantial simplification over CPT, however,
at the same time limits the flexibility of the theory.

The discontinuities of PT can be removed in a natural way by incorporating a central idea of

the “editing phase” by Kahneman and Tversky (1979) into the functional. The resulting
modified theory, smooth prospect theory (SPT) therefore, combines many of the advantages of
PT and CPT in one model.

With these improvements for the classical prospect theory, in particular the extension to non-
discrete lotteries, we built a foundation for applications of PT in financial economics and other
areas, where up to now the only possibility was to use the conceptually different and
numerically and analytically harder CPT.

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 RESEARCH PAPER 2
Prospect theory and the decision to move or stay
William A. V. Clarka,1
William Lisowskib

Objective: -
To investigate how the theoretical contributions of prospect theory, and specifically the
endowment effect, can provide new understanding about decisions whether to migrate or not.

The primary focus in studies of residential mobility is on the process of mobility: who moves,
and what is the underlying decision-making that leads to a move. While these studies implicitly
ask why the move did not occur, they have tended to focus primarily on how disruptions in the
life course (such as divorce and job change) have generated moves.

There is also a secondary, parallel interest in staying, and that literature focuses on the duration
of residence: on those who stayed and how long they stayed. Those studies relate duration to
levels of satisfaction with the dwelling and neighbourhood and community attachment. Thus,
the household’s familiarity with the local area, and its social ties, and feelings of security in the
current location all interact to increase the length of residence and lead to the decision not to
move.

Research Methodology: -
In this paper using Australian survey data, we provide an alternative focus, one which does not
privilege moving or staying but instead evaluates the moving or staying decision in the context
of both risk and a contextualized evaluation of the current situation. That is, we show how the
insights from prospect theory and the endowment effect—introduced at length below—can
help us understand the risky decision of whether to move or not. To sharpen the focus of our
models, we model migration—moves that entail leaving the local community, which have
greater uncertainty and attendant risk than moves within the local community. To some extent
the studies that examine the attachment of the household to their house and to their
neighbourhood—their familiarity with the area, their social ties, and their feelings of security,
and even their predisposition to stay (1)—have implicitly created the context for the analysis
we outline in the following study.
Significance
They used the prospect theory and the endowment effect to provide a theoretical basis for an
integrated approach to residential moving and residential staying. they linked measures of risk
aversion and the endowment effect to explain the trade-off between moving and staying. they
tested the Kahneman and Tversky’s observation that endowment effects are especially likely
in goods that are not regularly traded, e.g., houses. Their use value creates the endowment
effect, which works in favour of the locational status quo, increasing the probability of staying.
They analysed survey data to confirm that a general self-assessed risk aversion is important in
decisions to migrate or stay, and the endowment effect, measured as tenure and duration, is a
substantial factor in residential decision-making.

Conclusion: -
The contribution of this paper is to introduce a theoretical structure for the interrelated process
of moving and staying and so integrate the studies that have focused on movers and stayers.
We are able to show that while there are movers who are below the modal value of risk

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aversion, many more are stayers, while the opposite is true for those above the modal value,
where there are many more movers than stayers. That respondents can be movers or stayers is
conditioned on their demographic characteristics and the impact of life events, but the powerful
role of the endowment effect helps us understand just how staying is conditioned on duration.
It may not always be possible to use measures of risk as they have not routinely been collected
in studies of migration. However, the evidence from this research emphasizes that, even if risk
variables are unavailable, we can now provide a theoretical rationale for our studies of the way
in which duration matters in migration decisions. It is not duration per se that matters but that
duration is a proxy for endowment which in turn relies on the central contribution of prospect
theory, that it is gains and losses in relation to what a household already has which is the basis
of the evaluative process in migration decisions.

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 RESEARCH PAPER 3
An Introduction to Prospect Theory
Author(s): Jack S. Levy

Objective: -
1.To empirical anomalies in expected utility theory.
2.To explain Prospect Theory as a leading alternative to expected utility as a theory of decision
under risk.
3. To discuss both the framing of decisions and the evaluation of prospects in terms of a value
function and a probability weighting function.
4.To review the essential elements of the theory and to evaluate the
analytical problems that might affect its utility as a framework for research
in international relations and foreign policy.

Research methodology: -

The Descriptive foundations of Prospect theory are explained, before which a very brief review
of expected utility to bring forth the empirical violation of the latter theory and show how
prospect theory integrates these observed patterns into an alternative theory of risky choice.
Kahneman and Tversky (1979) begin by presenting the results of a series of laboratory
experiments involving hypothetical choices, and it would be useful to summarize some of the
most important findings here. Most of their examples refer to risky choice regarding monetary
outcomes, but many of their findings can be generalized to other forms of risky choice.

Limitations: -
1.There is no conclusive evidence on exactly how risk-averse or risk-acceptant
people are (or how much they are willing to sacrifice in expected value in order
to avoid a certain loss or secure a certain gain), even though Prospect Theory
claims individuals tend to be risk-averse with respect to gains and risk-acceptant
with respect to losses based on a series of laboratory experiments conducted by
Kahneman and Tversky.
2. We might expect laboratory studies to underestimate the true magnitude of endowment
effects at play while people take decisions.

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 RESEARCH PAPER 4
Loss Aversion Under Prospect Theory: A Parameter-Free Measurement
Mohammed Abdellaoui
Han Bleichrodt
Corina Paraschiv

Objectives: -
The purpose of this paper is to measure loss aversion at the individual level and without making
parametric assumptions.

Research methodology: -
They thus, obtain a parameter-free method to completely measure utility under prospect theory.
There are several advantages of using non-parametric instead of parametric measurements.

Our method is based on the elicitation of utility midpoints. Utility midpoints have often been
used in axiomatizations of decision models. A central step in our method is the elicitation of
probabilities (for decision under risk) or events (for decision under uncertainty) that have a
decision weight of 0.5. Such events can be interpreted as a generalization of Ramsey’s (1931)
ethically neutral events, i.e., events with subjective probability 0.5 under expected utility,
to prospect theory.

In the experiment, described in §4, we use our method to completely elicit utility under prospect
theory. After we determine the utility for gains and losses, we can measure the degree of loss
aversion according to the various definitions of loss aversion that have been put forward in the
literature.

Conclusion: -
We found clear evidence of loss aversion both at the aggregate and at the individual level. The
degree of loss aversion varied with the definition of loss aversion used. The elicitation
technique of this paper does not commit to a particular definition of loss aversion: it is “loss
aversion definition-free” so to speak. Two kinds of definition have been proposed in the
literature, global definitions and a local definition. Kahneman and Tversky (1979), Wakker and
Tversky (1993), Bowman et al. (1999), and Neilson (2002) have proposed global definitions
of loss aversion. To operationalize their definitions, they need to scan the specific utility
domain under study for any loss aversion measurement. The local definition of loss aversion,
informally proposed by Benartzi and Thaler (1995) and formalized by Köbberling and Wakker
(2005), measures loss aversion at the reference point and provides a natural “single-numbered
“measurement index for loss aversion. In this definition loss aversion becomes manifest in the
kink of the utility function at the reference point.

It is perhaps inevitable that when a new concept, like loss aversion, is introduced, disagreement
exists about its precise meaning and definition. Now that prospect theory seems to be emerging
as the dominant descriptive theory of decision under risk, and our findings appear to underline
this role, the need for a common definition of loss aversion becomes more urgent. Fully
resolving the debate about how to define loss aversion is beyond the scope of this paper.

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