Department of Economics
Prospect theory, indifference curves, and hedging risks
The prospect theory is one of the most popular decision-making theories. It is based on S-shaped utility functions, unlike the von Neumann and Morgenstern (NM) theory, which is based on concave utility functions. The S-shaped functions bring challenges, and extensions and generalizations of the NM theory into the prospect theory are not always possible. For example, in the prospect theory, the monotonicity of indifference curves depends on the underlying mean, unlike in the NM theory. Risk-hedging decisions also become more complex within the prospect theory. In this paper, we discuss these topics and establish general results concerning certain covariances from which we can in turn infer properties of indifference curves and hedging decisions within the prospect theory. © The Author 2010. Published by Oxford University Press. All rights reserved.
Source Publication Title
Applied Mathematics Research eXpress
Oxford University Press
Broll, Udo, Martín Egozcue, Wing-Keung Wong, and Riardas Zitikis. "Prospect theory, indifference curves, and hedging risks." Applied Mathematics Research eXpress 2010.2 (2010): 142-153.