Luppi, Barbara
(2005)

*Prospect theory and the law of small
numbers in the evaluation of asset prices.*
p. 28.
DOI

10.6092/unibo/amsacta/1787.

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## Abstract

We develop a model of one representative agent and one asset. The
agent evaluates the earnings according to Prospect Theory and he does
not know exactly the stochastic process generating earnings. While
the earnings are generated by a random walk process, the agent considers
a Markovian process, according to which firm’s earnings move
between two regimes, represented by a mean-reverting process and a
trend process, as in Barberis, Shleifer and Vishny (1998). We study
how an agent who is loss averse evaluates the price of a stock when
she takes into account the wrong stochastic process. This twofold departure
from rationality determines permanent effects on stock prices,
even in long run. First, the model shows that agent who evaluates
the asset according to Prospect Theory consistently underestimates
the asset, due to loss aversion bias. This is shown under two different
assumption regarding the functional form of utility. A kinked linear
utility function (as in Bernatzi and Thaler, 1985) and the original and
more general specification of Kahneman and Tversky (1979) are used.
The model allows to explain observed phenomenon in the cross-section
earnings return distribution. We solve this model and according to
Barberis et all (1998), we evaluate the framework by using artificial
data sets of earnings and prices simulated from the model. For plausible
range of parameter values, it generates the empirical predictions
of overreaction and underreaction observed in the data are explained.

Abstract

We develop a model of one representative agent and one asset. The
agent evaluates the earnings according to Prospect Theory and he does
not know exactly the stochastic process generating earnings. While
the earnings are generated by a random walk process, the agent considers
a Markovian process, according to which firm’s earnings move
between two regimes, represented by a mean-reverting process and a
trend process, as in Barberis, Shleifer and Vishny (1998). We study
how an agent who is loss averse evaluates the price of a stock when
she takes into account the wrong stochastic process. This twofold departure
from rationality determines permanent effects on stock prices,
even in long run. First, the model shows that agent who evaluates
the asset according to Prospect Theory consistently underestimates
the asset, due to loss aversion bias. This is shown under two different
assumption regarding the functional form of utility. A kinked linear
utility function (as in Bernatzi and Thaler, 1985) and the original and
more general specification of Kahneman and Tversky (1979) are used.
The model allows to explain observed phenomenon in the cross-section
earnings return distribution. We solve this model and according to
Barberis et all (1998), we evaluate the framework by using artificial
data sets of earnings and prices simulated from the model. For plausible
range of parameter values, it generates the empirical predictions
of overreaction and underreaction observed in the data are explained.

Tipologia del documento

Monografia
(Working paper)

Autori

Parole chiave

investor sentiment, loss aversion, overreaction, underreaction

Settori scientifico-disciplinari

DOI

Data di deposito

16 Feb 2006

Ultima modifica

17 Feb 2016 14:40

URI

## Altri metadati

Tipologia del documento

Monografia
(Working paper)

Autori

Parole chiave

investor sentiment, loss aversion, overreaction, underreaction

Settori scientifico-disciplinari

DOI

Data di deposito

16 Feb 2006

Ultima modifica

17 Feb 2016 14:40

URI

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