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Summary Of Prospect Theory

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Consider one of the most influential theories in behavioral finance, Prospect Theory, which is developed by Daniel Kahneman and Amos Tversky with their published paper in 1979, investors value gains and losses differently. Losses have more emotional impact to investors than an equivalent amount of gains. Prospect theory states that people are risk-averse in the domain of gains and risk-seeking in the domain of losses; according to a more specific behavior pattern (fourfold pattern of risk, Tversky & Kahneman, 1992), people are risk-averse for gains with high probability but risk-seeking for gains with low probability, while people are risk-seeking for losses with high probability but risk-averse for losses with low probability (Tversky & Kahneman, …show more content…

Additionally, trading volume should increase when the price of an IPO with a negative initial return exceeds the offer price for the first time. Kaustia (2004) finds support for the aggregate impact from the disposition effect on the subsample of negative initial return IPOs. Kaustia (2004) states that trading volume is clearly suppressed below the offer price for negative initial return IPOs, and turnover increases significantly at the time the stock price exceeds the offer price for the first time and continues to get higher while the stock is trading above the offer price. In this paper I inspect IPO trading volume and have some different findings that trading volume is significantly suppressed below the offer price for IPOs in 2003-2007 which is defined as the before-crisis period in Section 2 of this paper, and the effect does not continue to be significant during the following weeks since the offer. In addition, this paper also finds that trading volume is not significantly suppressed below the offer price for IPOs in the after-crisis period (details of period definition are discussed in Section 2). In this paper I also find that there is no significant difference in trading volume between before-crisis and after-crisis …show more content…

Shefrin & Statman (1985) suggest the purchase price to be the benchmark for investors who are unwilling to realize losses. Weber & Camerer (1998) suggest both the price of the previous period and purchase price to be important reference prices. Gneezy (2000) states the maximum and minimum stock prices are also potential reference points and the maximum stock price is even more significant than the purchase price. Heath et al. (1999) and Poteshman & Serbin (2003) state that attaining new highs in stock prices is a significant reference price in employee stock options and standardized exchange traded stock options respectively. Furthermore, Grinblatt & Keloharju (2001) and Kaustia (2004) find that new highs and lows of the past month are both important reference prices. In this paper I inspect the effect of different reference prices. The results are consistent with Kaustia (2004), which shows the relative importance of maximum and minimum stock prices as reference prices. Attaining new highs and lows over the previous month can increase the daily turnover significantly as similar as the results of Kaustia (2004). The effect is very significant for all subsamples of this paper, where new highs are more important by comparing their estimate

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A few works, however, review moderators of loss aversion in a challenge to grasp its underlying mechanisms. For instance, Van Dijk and Van Knippenberg (1998) (see also Chapman 1998) uses a comparable exchange, substitution class as Knetsch’s (1989) and finds that the endowment effect is concentrated when the endowed and not equipped items are similar, signifying that loss aversion is correlated to the exchangeability of goods in an interchange. Other works demonstrate that loss aversion can build up over time, disclosing that a shorter period of ownership decreases loss aversion (Strahilevitz and Loewenstein 1998). More recently, research has demonstrated that the designation of less of a fixed amount of money for necessities leads to decreased loss aversion (Wicker et al. 2001), proposing that the availability of expendable resources mitigates loss aversion. Carmon and Ariely (2000) suggest that the different perceptions of buyers and sellers underlie loss aversion; they find that directing buyers on the benefits of the object and sellers on alternative uses of money attenuates the endowment effect.

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One of the leading theories of human decision making is Prospect Theory (Kahneman & Tversky, 1979). It is a more psychologically accurate approach to describing human decision making, compared to the expected utility theory. In particular, an important element of prospect theory, reference-dependent preferences, is based on the main idea that an individual’s assessment of an outcome, is not only determined by the outcome itself but how the outcome compares to a reference point. In doing so, it typically assumes that outcomes relative to the reference point; are evaluated by an S-shaped value function – capturing two key components: loss aversion (suggesting losses hurt more than gains feel good) and diminishing sensitivity (by being convex

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With the recent complicated economic financial environments, there may be some abnormal relationships comparing with the theories. We cannot examine them in the project. 3.

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The principal idea in prospect theory is that individuals derive utility from “gains” and “losses” measured relative to a reference point. However, it is every so often indistinct to define specifically what a gain or a loss is – especially since Kahneman and Tversky offered relatively little guidance on how the reference point is determined (Barberis, 2013). One example this is predicting what kind of portfolio an investor will hold. Which “gains” and “losses” is the investor thinking about? Are they gains and losses in the value of specific stocks, in the value of total stock market holdings, or in overall wealth?

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