Pls answer all parts for UPVOTE a) Explain prospect theory. Use an example to il
ID: 2820338 • Letter: P
Question
Pls answer all parts for UPVOTE
a) Explain prospect theory. Use an example to illustrate one implication of the theory. Some claims that people can be extremely risk averse so that they value a risky prospect less than the prospect’s worst possible outcome based on prospect theory. Is that right? Justify your answer.
b) Define the uncertainty effect (UE). What are the three possible reasons for the UE? Simonsohn (2009) examined the rationale behind the UE using experiments. Summarize the findings from the experiments.
c) The efficient market hypothesis predicts that “the future returns on the two portfolios, the Winners and the Losers, should be the same since you are not supposed to be able to predict changes in stock prices from past returns.” Thaler (2018) mentioned that he and his coauthors had a different prediction. What was their prediction? Explain the rationale behind their prediction
Explanation / Answer
This theory was formulated in 1979 and further developed in 1992 by Amos Tversky and Daniel Kahneman, deeming it more psychologically accurate of how decisions are made when compared to the expected utility theory. The underlying explanation for an individual’s behavior, under prospect theory, is that because the choices are independent and singular, the probability of a gain or a loss is reasonably assumed as being 50/50 instead of the probability that is actually presented. Essentially, the probability of a gain is generally perceived as greater
Example:assume that the end result is receiving $50. One option is being given the straight $50. The other option is gaining $100 and losing $50. The utility of the $50 is exactly the same in both options. However, individuals are most likely to choose receiving the straight cash because a single gain is generally observed as more favorable than initially having more cash and then suffering a loss.