Prospect Theory, Indifference Curves, and Hedging Risks

13 Pages Posted: 12 Jun 2010

See all articles by Udo Broll

Udo Broll

Dresden University of Technology - Faculty of Economics and Business Management

Martin Egozcue

Universidad de la Republica; University of Montevideo

Ricardas Zitikis

Western University

Wing-Keung Wong

Asia University, Department of Finance

Date Written: June 10, 2010

Abstract

The prospect theory is one of the most popular decision-making theories. It is based on the S-shaped utility function, unlike the von Neumann and Morgenstern (NM) theory, which is based on the concave utility function. The S-shape brings in mathematical challenges: simple extensions and generalizations of NM theory into the prospect theory cannot be frequently achieved. For example, the nature of monotonicity of the indifference curve depends on the underlying mean. Price hedging decisions also become more complex within the prospect theory. We discuss these topics in detail and offer a general result concerning the sign of a covariance from which we then infer desired properties of the indifference curve and also justify hedging decisions within the prospect theory. We illustrate our general considerations with a thoroughly worked out example.

Keywords: Prospect theory, mean-variance model, indifference curve, production output, price uncertainty, hedging, contango, backwardation

Suggested Citation

Broll, Udo and Egozcue, Martin and Egozcue, Martin and Zitikis, Ricardas and Wong, Wing-Keung, Prospect Theory, Indifference Curves, and Hedging Risks (June 10, 2010). Available at SSRN: https://ssrn.com/abstract=1623057 or http://dx.doi.org/10.2139/ssrn.1623057

Udo Broll

Dresden University of Technology - Faculty of Economics and Business Management ( email )

Mommsenstrasse 13
Dresden, D-01062
Germany

Martin Egozcue

Universidad de la Republica ( email )

Av. 18 de Julio
Montevideo, 1968
Uruguay

University of Montevideo ( email )

Montevideo, 20100
Uruguay

Ricardas Zitikis

Western University ( email )

1151 Richmond Street
Suite 2
London, Ontario N6A 5B8
Canada

Wing-Keung Wong (Contact Author)

Asia University, Department of Finance ( email )

Taiwan
Taiwan

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