Prospect theory

Question 1

two ways of having a preference relation

Answer 1

complete: always define preference between x and y transitive: if x>y and y>z then x>z

Question 2

a preference relation between goods is rational if…

Answer 2

complete or transitive preference relationship

Question 3

what is monotone

Answer 3

more is preferred to less

Question 4

what is convex

Answer 4

diminishing marginal rates of substitutions (agents prefer diversification)

Question 5

what is independence

Answer 5

if x>y then (x,z)>(y,z)

Question 6

what is continuity

Answer 6

if A>B>C then there is always a p such that A and C weighted equals B (5/31 don’t rly get)

Question 7

what are main assumptions of expected utility theory

Answer 7

continuity independence linear in probability

Question 8

what is linear in probability

Answer 8

V(q) = Σpiu(xi)

Question 9

what are the other assumptions in expected utility theory

Answer 9

utility defined over final wealth rather than gains and losses, preferences are independent on the manner the prospects are described

Question 10

what are the puzzles of EU theory

Answer 10

framing effects (dying and saving people) loss aversion (losses loom larger than gain), utility not defined over final wealth (100k vs 50k happy 100k vs 500k sad), linear decision weights

Question 11

what is the Allais paradox (linear decision weights)

Answer 11

A=(4000,.80) or B=(3000,1) C=(4000,0.20) or D=(3000,0.25) people prefer B to A and C to D. C&D obtained by dividing probabilities by 4. reducing probability of winning from 1 to 0.25 has a greater effect than reducing it from 0.8 to 0.2 (certainty effect)

Question 12

what does it mean that individuals are risk averse in gains and risk lovers in losses

Answer 12

diff between gain of 100 to 200 appears larger than 1100 and 1200, diff between loss of -100 and -200 appears larger than -1100 and -1200. hence v’‘(x)<0 for x>0 and v’‘(x)>0 for x<0

Question 13

what does risk loving in losses mean

Answer 13

in order to avoid losses you will do crazy things (irrational risk)

Question 14

what is π(p)

Answer 14

weighting function: probability is a function of π

Question 15

in prospect theory how is the decision weight used

Answer 15

the value of an uncertain outcome is multiplied by a decision weight π(p) which is a monotonic function of p but is not a probability (in EU just multiplied by probability)

Question 16

explain mug experiment and who wrote it*

Answer 16

kahneman et al (1990), market for mugs (6 USD) some were endowed a mug some others with money to buy, median WTP=2.75 mediam WTA=5.25

Question 17

why is mug experiment of note

Answer 17

standard assumptions imply WTA≈WTP, evidence of endowment effect: value things you own more than things you don’t. this type of loss aversion implies asymmetry in treatment of losses and foregone gains

Question 18

WTP and WTA d

Answer 18

willingness to accept: minimum compensation demanded by owner to sell willingness to pay: max price individuals want to pay for a good

Question 19

what is the disposition effect in terms of stocks

Answer 19

individuals hold stock that have lost value for too long and are eager to sell stocks that have gained value

Question 20

first field experiment of brokerage firm*

Answer 20

shefrin and statman (1985) field experiment brokerage firm investors held losing stocks median 124 days and held winners only 104 days

Question 21

what is another similar example to investors holding stocks that have lost value for too long and sell gainers

Answer 21

similar effect in housing market when house price falls the volume of sales falls as well

Question 22

Odean (1998)*

Answer 22

info from discount brokerage house 1987-1993. share of realised gains PGR=realisedgains/realisedgains+papergains (PLR opposite)(this controls for the market) PGR greater than PLR people more reluctant to realise losses than gains however in December PLR>PGR because if you have more losses you get taxed less at end of year

Question 23

why do you need paper gains as well

Answer 23

because if bull market would naturally have more winners than losers. need to look at frequency with which they sell winners and losers relative to their opportunities to sell winners and losers

Question 24

talk about cab driver paper*

Answer 24

Camerer et al. (1997), cab drivers lease cabs for fixed fee, they work long hours when there is low demand (sunny) and short hours when high demand (rainy), this is consistent with loss aversion: fix a daily target and averse to fall short standard theory says should respond positively to wage changes (work more when wage higher,(leisure cost more))

Question 25

how does the cab driver link with loss aversion

Answer 25

notion that drivers are averse to falling below a target income, almost consistent with loss aversion

Question 26

why study NYC cabs

Answer 26

exogenous wage fluctuations due to weather, subway breakdowns etc, make labour supply decisions each day and have a target wage, this motivates study of their behaviour as one-day target predicts negative elasticities.

Question 27

what is prospect theory

Answer 27

when faced with simple 2 or 3 outcome lotteries, people behave as if maximising S-shaped value function that is defined on gains and losses rather than on levels of wealth

Question 28

explain shape of prospect theory value function

Answer 28

concave in domain of gains and convex in domain of losses. steeper for losses than gains, implies people are generally risk-averse. critical to value function is the reference point from which gains and losses measured, its usually the status quo but could be expectation or aspiration level

Question 29

what does certainty effect lead to from Kahneman et al (1990)

Answer 29

contributes to risk aversion in choices involving sure gains and to risk seeking in choices involving sure losses

Question 30

what is the certainty effect and which paper is it from

Answer 30

people overweight outcomes that are considered certain, relative to outcomes that are merely probable

Question 31

what is the reflection effect

Answer 31

risk aversion in the positive domain is accompanies by risk seeking in the negative domain (people willing to accept risk .8 to lose 4000 over a sure loss of 3000)

Question 32

what is the isolation effect

Answer 32

in order to simplify the choice between alternatives, people often disregard components that the alternatives share, and focus on the components that distinguish them., this produces inconsistent preferences as prospects can be decomposed in different ways leading to diff choices

Question 33

what is the key feature of prospect theory

Answer 33

carriers of value are changes in wealth or welfare, rather than final stages

Question 34

in prospect theory what happens to the value of each outcome

Answer 34

multiplied by a decision weight, decision weights are inferred from choices between prospects

Question 35

How are decision weights different to probabilities

Answer 35

decision weights measure the impact of events on the desirability of prospects, not merely the perceived likelihood of these events

Question 36

what is loss aversion

Answer 36

losses loom larger than gains, Status-quo Bias (Endowment represents the status-quo)

Question 37

PGR PLR

Answer 37

proportion of realised gains/losses

Question 38

what is the conclusion of the Odean (1998) paper

Answer 38

a large difference in the proportion of realised gains (PGR) and realised losses (PLR) indicates that investors are more willing to realise either gains or losses

Question 39

what are some properties of π

Answer 39

impossible events are discarded π(0)-0, the function is not well behaved near end points, for low probabilities π(p)>p, thus low probabilities overweighted, moderate and high probabilities underweighted and latter more pronounced than former

Question 40

what is the principle of diminishing sensitivity

Answer 40

the effect of a change diminishes with the distance to the reference point

Question 41

what does complete mean

Answer 41

Complete: it is always possible to define preferences between

good x and y

Question 42

what is transitive

Answer 42

Transitive: if x > y and y > z then x > z