Financial Market Equilibria with Cumulative Prospect Theory
34 Pages Posted: 14 May 2007 Last revised: 13 Jan 2021
Date Written: July 7, 2009
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: Suggested Citation