Financial Market Equilibria with Cumulative Prospect Theory

34 Pages Posted: 14 May 2007 Last revised: 13 Jan 2021

See all articles by Enrico G. De Giorgi

Enrico G. De Giorgi

University of St. Gallen - SEPS: Economics and Political Sciences; Swiss Finance Institute

Thorsten Hens

University of Zurich - Department of Banking and Finance; Norwegian School of Economics and Business Administration (NHH); Swiss Finance Institute

Marc Oliver Rieger

University of Trier

Date Written: July 7, 2009

Abstract

The paper first shows that financial market equilibria need not to exist if agents possess cumulative prospect theory preferences with piecewise-power value functions. This is due to the boundary behavior of the cumulative prospect theory value function, which might cause an infinite short-selling problem. But even when a nonnegativity constraint on final wealth is added, non-existence can occur due to the non-convexity of CPT preferences, which might cause discontinuities in the agents' demand functions. This latter observation also implies that concavification arguments which has been used in portfolio allocation problems with CPT preferences do not apply to our general equilibrium setting with finite many agents. Existence of equilibria is established when non-negativity constraints on final wealth are imposed and there is a continuum of agents in the market. However, if the original prospect theory is used instead of cumulative prospect theory, then other discontinuity problems can cause non-existence of market equilibria even in this case.

Keywords: Cumulative prospect theory, general equilibrium model, non-convex preferences, continuum of agents

JEL Classification: G11, D81

Suggested Citation

De Giorgi, Enrico G. and Hens, Thorsten and Rieger, Marc Oliver, Financial Market Equilibria with Cumulative Prospect Theory (July 7, 2009). Swiss Finance Institute Research Paper No. 07-21, Available at SSRN: https://ssrn.com/abstract=985539 or http://dx.doi.org/10.2139/ssrn.985539

Enrico G. De Giorgi (Contact Author)

University of St. Gallen - SEPS: Economics and Political Sciences ( email )

Department of Economics
Bodanstrasse 6
CH-9000 St. Gallen
Switzerland
+41712242430 (Phone)

Swiss Finance Institute ( email )

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Thorsten Hens

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 32
Zurich, 8032
Switzerland
+41-44 634 37 06 (Phone)

Norwegian School of Economics and Business Administration (NHH)

Helleveien 30
Bergen, 5045
Norway

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

Marc Oliver Rieger

University of Trier ( email )

15, Universitaetsring
Trier, 54286
Germany

HOME PAGE: http://www.banking-finance.uni-trier.de

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