Journal Article

Prospect Theory, Indifference Curves, and Hedging Risks

Udo Broll, Martín Egozcue, Wing-Keung Wong and Ričardas Zitikis

in Applied Mathematics Research eXpress

Volume 2010, issue 2, pages 142-153
Published in print January 2010 | ISSN: 1687-1200
Published online January 2010 | e-ISSN: 1687-1197 | DOI: https://dx.doi.org/10.1093/amrx/abq013
Prospect Theory, Indifference Curves, and Hedging Risks

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The prospect theory is one of the most popular decision-making theories. It is based on S-shaped utility functions, unlike the von Neumann and Morgenstern (NM) theory, which is based on concave utility functions. The S-shaped functions bring challenges, and extensions and generalizations of the NM theory into the prospect theory are not always possible. For example, in the prospect theory, the monotonicity of indifference curves depends on the underlying mean, unlike in the NM theory. Risk-hedging decisions also become more complex within the prospect theory. In this paper, we discuss these topics and establish general results concerning certain covariances from which we can in turn infer properties of indifference curves and hedging decisions within the prospect theory.

Journal Article.  2914 words.  Illustrated.

Subjects: Applied Mathematics

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