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Probability weighting, stop-loss and the disposition effect

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Henderson, Vicky, Hobson, David G. and Tse, Alex S. L. (2018) Probability weighting, stop-loss and the disposition effect. Journal of Economic Theory, 178 . pp. 360-397. doi:10.1016/j.jet.2018.10.002

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Official URL: https://doi.org/10.1016/j.jet.2018.10.002

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Abstract

In this paper we study a continuous-time, optimal stopping model of an asset sale with prospect theory preferences under pre-commitment. We show for a wide range of value and probability weighting functions, including those of Tversky and Kahneman (1992), that the optimal prospect takes the form of a stop-loss threshold and a distribution over gains. It is skewed with a long right tail. This is consistent with both the widespread use of stop-loss strategies in financial markets, and recent experimental evidence. Moreover, our model with probability weighting in tandem with the S-shaped value function makes predictions for the disposition effect which match in magnitude that calculated by Odean (1998).

Item Type: Journal Article
Subjects: H Social Sciences > HG Finance
Q Science > QA Mathematics
Divisions: Faculty of Science > Statistics
Library of Congress Subject Headings (LCSH): Finance -- Mathematical models, Economics -- Psychological aspects -- Mathematical models
Journal or Publication Title: Journal of Economic Theory
Publisher: Elsevier
ISSN: 0022-0531
Official Date: November 2018
Dates:
DateEvent
November 2018Published
10 October 2018Available
13 September 2018Accepted
Volume: 178
Page Range: pp. 360-397
DOI: 10.1016/j.jet.2018.10.002
Status: Peer Reviewed
Publication Status: Published
Access rights to Published version: Restricted or Subscription Access
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