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Time, Arbitrage, and the Law of One Price: The Case for a Paradigm Shift
Abstract
Consider a Competitive, Efficient, and Frictionless Economy (CEFE) where resources are scarce at any date, and hence money as a valid claim against scarce resources is also scarce. In this economy, there is always price competition, which can at any date generate an unlimited number of arbitrage opportunities. For example, at any date, opportunities can exist to buy and sell each one of the contracts for delivery of the same good or asset at multiple prices currently as well as on an infinite number of future dates. I prove all arbitrage transactions, including “spot” transactions, tie up arbitrageurs’ capital representing money, good or asset such that this capital cannot be used for any other purpose for a non-zero quantity of time. This makes it impossible to exploit all arbitrage opportunities with the scarce capital available at any date and leads to an infinite number of unexploited opportunities and a non-negligible opportunity cost of the capital tied-up in arbitrage transactions, represented by each arbitrageur’s best missed arbitrage opportunity, if no better opportunity exits, hence the breakdown of the law of one price in its standard sense. This helps construct a new paradigm of CEFE which resolves long-standing theoretical, empirical, and experimental puzzles.
... Konsep ini berkaitan dengan dampak arbitrase pasar dan perdagangan pada harga komoditas identik yang dipertukarkan di dua pasar atau lebih. Konsep hukum satu harga dengan ini menegasikan adanya realitas atas pasar yang tidak sempurna [6,7,12,13]. Argumen dasar atas konsep ini dihadapkan pada pasar yang efisien, di mana seharusnya hanya ada satu harga komoditas identik tersebut, di negara manapun komoditas tersebut perdagangkan. ...
... Argumen dasar atas konsep ini dihadapkan pada pasar yang efisien, di mana seharusnya hanya ada satu harga komoditas identik tersebut, di negara manapun komoditas tersebut perdagangkan. Namun, karena adanya biaya transportasi dan transaksi atas suatu komoditas, konsep hukum satu harga harus dirumuskan ulang ketika diterapkan pada perdagangan spasial [6,7,12,13]. ...
... Hukum satu harga hanya memperhitungkan frictionless market, di mana tidak ada biaya transaksi, biaya transportasi, batasan hukum, nilai tukar mata uang yang sama, dan tidak ada manipulasi harga oleh pembeli atau penjual. Hukum satu harga ada karena perbedaan antara harga aset di lokasi yang berbeda pada akhirnya akan terhapus karena adanya peluang arbitrase [6,7,12,13,14]. Menurut konsep ini, peluang arbitrase akan tercapai di mana pedagang akan membeli komoditi di pasar yang tersedia dengan harga lebih rendah dan kemudian menjualnya di pasar yang tersedia dengan harga lebih tinggi. Seiring waktu, kekuatan ekuilibrium pasar akan menyelaraskan harga setiap komoditi [7,12]. ...
This study aims to prove the existence of the absolute purchasing power parity theory using The Big Mac Index and take the example of The Six Cheapest countries, two of which are Indonesia and Malaysia. The data taken is secondary data that has been measured and processed by The Economist which contains the prices of the Big Mac units sold by each country, in The Big Mac Index is 56 countries with different incomes. The method used is a descriptive method, with the literature method technique. The results show that in the end absolute purchasing power parity will not be formed in the free market. This is stated by the non-meeting points of purchasing power parity under conditions of real consumption. Also, it is proven by the undervalued value of the rupiah and ringgit in Indonesia and Malaysia against the US dollar, as well as the level of consumption of each country that must be adjusted.
... Many factors are indicated in the literature, however Sexton et al. (1991) categorise the factors into three as those causing markets not to be linked by arbitrage, those posing impediments to efficient arbitrage and those causing imperfect competition in markets. too high transaction costs and marketing margins are usually cited as the factors that hinder the transmission of price signals and prohibit arbitrage (Badiane & Shively, 1998;Falahati, 2019;rapsomanikis et al., 2003). among the factors that impede efficient arbitrage lutz et al. (1995) mention the characteristics of agricultural production, marketing and consumption such as seasonality, inadequate infrastructure, market entry barriers and unreliable market information. ...
IMPACT statement
Plantain’s role as a source of food and income among Ghanaian households cannot be overemphasized. However, like it is with many African countries, inefficiency in marketing the product is prevalent in the country. There are many marketing problems that smallholder farmers encounter which determine how far plantain production can be expanded. Various efforts have been made by governments to address the marketing situation of staple food crops, in general, but they appear to be inadequate. Yet, marketing of plantain has not received as much attention as is given to its production. This study ascertains the efficiency of the plantain marketing system in mid Ghana by estimating the extent of spatial integration of plantain markets in the area. Analysis showed that there exists both long-run and short-run market integration among plantain markets in mid Ghana, albeit weak in each case. Suggestions to improve situations are provided.
... The progress in econometrics over the past 30 years added hundreds of papers to the PPP's literature. Failure to find empirical evidence of the PPP relationship in the empirical literature has identified the PPP puzzle as one of the six major puzzles in international economics (see for example Chen and Engel 2005;Falahati 2019;Ford and Horioka 2017;Frydman et al. 2009;Horioka and Ford 2017;Imbs et al. 2005;Johansen and Juselius 1992;Razzak 2018). ...
Johansen’s (2000. “A Bartlett Correction Factor for Tests of on the Cointegrating Relations.” Econometric Theory 16: 740–78) Bartlett correction factor for the LR test of linear restrictions on cointegrated vectors is derived under the i.i.d. Gaussian assumption for the innovation terms. However, the distribution of most data relating to financial variables is fat-tailed and often skewed; there is therefore a need to examine small sample inference procedures that require weaker assumptions for the innovation term. This paper suggests that using the non-parametric bootstrap to approximate a Bartlett-type correction provides a statistic that does not require specification of the innovation distribution and can be used by applied econometricians to perform a small sample inference procedure that is less computationally demanding than it’s analytical counterpart. The procedure involves calculating a number of bootstrap values of the LR test statistic and estimating the expected value of the test statistic by the average value of the bootstrapped LR statistic. Simulation results suggest that the inference procedure has good finite sample property and is less dependent on the parameter space of the data generating process.
... We conclude by stating what seems obvious to many outside the economics profession, and to many inside it but thinking outside the neoclassical paradigm: Economics needs a new and much more solid foundation than the currently dominant paradigm, such that it defines the key characteristics of the economy and its players much more aptly and precisely, with a much more rigorous application of logic and mathematics than applied hereto, such that it avoids any internal inconsistency; as a pre-requisite to achieve external consistency. To see how this can be done, readers may consult Falahati (2012Falahati ( , 2019aFalahati ( , 2019b, where a vast number of theoretical, empirical and behavioral puzzles in microeconomics, financial economics and macroeconomics are resolved. ...
In most scientific disciplines, mathematical models work well empirically and experimentally. However, it is widely recognized that in standard (i.e. neoclassical) economics, mathematical models do not work quite as well, not even at the theoretical level. The question is why. This diagnostic study, which is one of the first in its kind, addresses this question and reveals that mathematics is non-rigorously applied in economics by focusing on the case of ordinal utility theory (which rests at the foundation of neoclassical economics), and identifying three mathematical oversights there. For these reasons, this paper calls for a reconstruction of economic theory with a much more solid foundation than that of the currently dominant paradigm, and with a much more rigorous application of logic and mathematics.
Expected utility theory (EUT) is currently the standard framework which formally defines rational decision-making under risky conditions. EUT uses a theoretical device called von Neumann–Morgenstern utility function, where concepts of function and random variable are employed in their pre-set-theoretic senses. Any von Neumann–Morgenstern utility function thus derived is claimed to transform a non-degenerate random variable into its certainty equivalent. However, there can be no certainty equivalent for a non-degenerate random variable by the set-theoretic definition of a random variable, whilst the continuity axiom of EUT implies the existence of such a certainty equivalent. This paper also demonstrates that rational behaviour under utility theory is incompatible with scarcity of resources, making behaviour consistent with EUT irrational and justifying persistent external inconsistencies of EUT. A brief description of a new paradigm which can resolve the problems of the standard paradigm is presented. These include resolutions of such anomalies as endowment effect, asymmetric valuation of gains and losses, intransitivity of preferences as well as the St. Petersburg Paradox.
I describe how in the new paradigm of a Competitive, Efficient, and Frictionless Economy (CEFE), introduced in Falahati (2019), macroeconomic imbalances with fluctuating levels of liquidity emerge endogenously. This provides a solid foundation for studying Minsky’s views on financial instability in an economy with a banking and risk-underwriting system. I identify an inverse relationship between liquidity premia and risk premia, which leads to endogenous risk-premium rating cycles, including credit-risk-premium rating cycles, and macroeconomic swings. Ceteris paribus, lower liquidity increases the prices of contracts covering risks (e.g., credit default swaps), whist it decreases prices of all other assets. The opposite occurs with higher liquidity. I analyze operations of banks, risk-underwriters, and the State/Central Bank, and present a new theory of banking which improves current understandings. This theory explains how a banking system uses the floating capital of the economy more efficiently, while it also generates greater systemic risks, compared to an economy without banks. I show how the banking system can induce macroeconomic booms and busts and generate endogenous asset price bubbles and bursts. I highlight other systemic problems of the economy and derive their implications for improving the financial management of the economy and its institutions.
The central claim in this paper is that by explicitly introducing costs of international trade (narrowly, transport costs but more broadly, tariffs, nontariff barriers and other trade costs), one can go far toward explaining a great number of the main empirical puzzles that international macroeconomists have struggled with over twenty-five years. Our approach elucidates J. McCallum's home bias in trade puzzle, the Feldstein-Horioka saving-investment puzzle, the French-Poterba equity home bias puzzle, and the Backus-Kehoe-Kydland consumption correlations puzzle. That one simple alteration to an otherwise canonical international macroeconomic model can help substantially to explain such a broad arrange of empirical puzzles, including some that previously seemed intractable, suggests a rich area for future research. We also address a variety of international pricing puzzles, including the purchasing power parity puzzle emphasized by Rogoff, and what we term "the exchange rate disconnect puzzle." The latter category of riddles includes both the Meese-Rogoff exchange rate forecasting puzzle and the Baxter-Stockman neutrality of exchange rate regime puzzle. Here, although many elements need to be added to our extremely simple model, trade costs still play an essential role.
Conducted 3 experiments in which undergraduate males (N = 261) chose their preferred bet from pairs of bets and later bid for each bet separately. In each pair, 1 bet had a higher probability of winning (P bet); the other offered more to win ( bet often received a higher bid. It is concluded that these inconsistencies violate every risky decision model, but can be understood via information-processing considerations. In bidding, S starts with amount to win and adjusts it downward to account for other attributes of the bet. In choosing, there is no natural starting point: amount to win dominates bids but not choices. (PsycINFO Database Record (c) 2012 APA, all rights reserved)
Discusses the cognitive and the psychophysical determinants of choice in risky and riskless contexts. The psychophysics of value induce risk aversion in the domain of gains and risk seeking in the domain of losses. The psychophysics of chance induce overweighting of sure things and of improbable events, relative to events of moderate probability. Decision problems can be described or framed in multiple ways that give rise to different preferences, contrary to the invariance criterion of rational choice. The process of mental accounting, in which people organize the outcomes of transactions, explains some anomalies of consumer behavior. In particular, the acceptability of an option can depend on whether a negative outcome is evaluated as a cost or as an uncompensated loss. The relationships between decision values and experience values and between hedonic experience and objective states are discussed. (27 ref)
Contrary to theoretical expectations, measures of willingness-to-accept greatly exceed measures of willingness-to-pay. This paper reports several experiments that demonstrate that this "endowment effect" persists even in market settings with opportunities to learn. Consumption objects (e.g., coffee mugs) are randomly given to half the subjects in an experiment. Markets for the mugs are then conducted. The Coase theorem predicts that about half the mugs will trade, but observed volume is always significantly less. When markets for "induced-value" tokens are conducted, the predicted volume is observed, suggesting that transactions costs cannot explain the undertrading for consumption goods. Copyright 1990 by University of Chicago Press.
In the hope that it may help to overcome these obstacles to effective empirical testing, this paper will attempt to fill the existing gap in the theoretical literature on valuation. We shall begin, in Section I , by examining the effects the effects of differences in dividend policy on the current price of shares in an ideal economy characterized by perfect capital markets, rational behavior, and perfect certainty. Still within this convenient analytical framework we shall go on in Section II and III to consider certain closely related issues that appear to have been responsible for considerable misunderstanding of the role of dividend policy. In particular, Section II will focus on the longstanding debate about what investors "really" capitalize when they buy shares; and Section III on the much mooted relations between price, the rate of growth of profits, and the rate of dividends per share. Once these fundamentals have been established, we shall proceed in Section IV to drop the assumption of certainty and to see the extent to which the earlier conclusions about dividend policy must be modified. Finally, in Section V , we shall briefly examine the implications for the dividend policy problem of certain kinds of market imperfections.
The central claim in this paper is that by explicitly introducing costs of international trade (narrowly, transport costs but more broadly, tariffs, nontariff barriers and other trade costs), one can go far toward explaining a great number of the main empirical puzzles that international macroeconomists have struggled with over twenty-five years. Our approach elucidates J. McCallum's home bias in trade puzzle, the Feldstein-Horioka saving-investment puzzle, the French-Poterba equity home bias puzzle, and the Backus-Kehoe-Kydland consumption correlations puzzle. That one simple alteration to an otherwise canonical international macroeconomic model can help substantially to explain such a broad arrange of empirical puzzles, including some that previously seemed intractable, suggests a rich area for future research. We also address a variety of international pricing puzzles, including the purchasing power parity puzzle emphasized by Rogoff, and what we term "the exchange rate disconnect puzzle." The latter category of riddles includes both the Meese-Rogoff exchange rate forecasting puzzle and the Baxter-Stockman neutrality of exchange rate regime puzzle. Here, although many elements need to be added to our extremely simple model, trade costs still play an essential role.
In a choice among assured, familiar outcomes of behavior, impulsiveness is the choice of less rewarding over more rewarding alternatives. Discussions of impulsiveness in the literature of economics, sociology, social psychology, dynamic psychology and psychiatry, behavioral psychology, and "behavior therapy" are reviewed. Impulsiveness seems to be best accounted for by the hyperbolic curves that have been found to describe the decline in effectiveness of rewards as the rewards are delayed from the time of choice. Such curves predict a reliable change of choice between some alternative rewards as a function of time. This change of choice provides a rationale for the known kinds of impulse control and relates them to several hitherto perplexing phenomena: behavioral rigidity, time-out from positive reinforcement, willpower, self-reward, compulsive traits, projection, boredom, and the capacity of punishing stimuli to attract attention. (31/2 p ref)
We argue that the Cambridge capital theory controversies of the 1950s to 1970s were the latest in a series of still-unresolved controversies over three deep issues: explaining and justifying the return to capital; Joan Robinson's complaint that, due to path dependence, equilibrium is not an outcome of an economic process and therefore an inadequate tool for analyzing accumulation and growth; and the role of ideology and vision in fuelling controversy when results of simple models are not robust. We predict these important and relevant issues, latent in endogenous growth and real business cycle theories, will erupt in future controversy.
A body of data and theory has been developing
within psychology which should be of
interest to economists. Taken at face value the
data are simply inconsistent with preference
theory and have broad implications about
research priorities within economics. The
inconsistency is deeper than the mere lack of
transitivity or even stochastic transitivity. It
suggests that no optimization principles of
any sort lie behind even the simplest of human
choices and that the uniformities in human
choice behavior which lie behind market
behavior may result from principles which are
of a completely different sort from those
generally accepted. This paper reports the
results of a series of experiments designed to
discredit the psychologists' works as applied
to economics.
This paper describes the firm not as a production function (which is a black box construction) but as a governance structure (which is an organizational construction). This is accomplished by examining economic organization through the lens of contract rather than through the more traditional lens of choice. Firm and market are viewed in a comparative institutional way as alternative modes of governance, where governance serves the three-part purpose of infusing order, thereby to mitigate potential conflict and realize mutual gains. Transaction cost economizing drives much of the argument. Refutable implications, empirical testing and public policy ramifications all accrue to this setup.
A wine-loving economist we know purchased some nice Bordeaux wines years ago at low prices. The wines have greatly appreciated in value, so that a bottle that cost only 200 at auction. This economist now drinks some of this wine occasionally, but would neither be willing to sell the wine at the auction price nor buy an additional bottle at that price. Thaler (1980) called this pattern—the fact that people often demand much more to give up an object than they would be willing to pay to acquire it—the endowment effect. The example also illustrates what Samuelson and Zeckhauser (1988) call a status quo bias, a preference for the current state that biases the economist against both buying and selling his wine. These anomalies are a manifestation of an asymmetry of value that Kahneman and Tversky (1984) call loss aversion—the disutility of giving up an object is greater that the utility associated with acquiring it. This column documents the evidence supporting endowment effects and status quo biases, and discusses their relation to loss aversion.
I describe how in the new paradigm of a Competitive, Efficient, and Frictionless Economy (CEFE), introduced in Falahati (2019), macroeconomic imbalances with fluctuating levels of liquidity emerge endogenously. This provides a solid foundation for studying Minsky’s views on financial instability in an economy with a banking and risk-underwriting system. I identify an inverse relationship between liquidity premia and risk premia, which leads to endogenous risk-premium rating cycles, including credit-risk-premium rating cycles, and macroeconomic swings. Ceteris paribus, lower liquidity increases the prices of contracts covering risks (e.g., credit default swaps), whist it decreases prices of all other assets. The opposite occurs with higher liquidity. I analyze operations of banks, risk-underwriters, and the State/Central Bank, and present a new theory of banking which improves current understandings. This theory explains how a banking system uses the floating capital of the economy more efficiently, while it also generates greater systemic risks, compared to an economy without banks. I show how the banking system can induce macroeconomic booms and busts and generate endogenous asset price bubbles and bursts. I highlight other systemic problems of the economy and derive their implications for improving the financial management of the economy and its institutions.
We find that deviations from the covered interest rate parity (CIP) condition imply large, persistent, and systematic arbitrage opportunities in one of the largest asset markets in the world. Contrary to the common view, these deviations for major currencies are not explained away by credit risk or transaction costs. They are particularly strong for forward contracts that appear on banks' balance sheets at the end of the quarter, pointing to a causal effect of banking regulation on asset prices. The CIP deviations also appear significantly correlated with other fixed income spreads and with nominal interest rates.
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An arbitrage opportunity is an investment strategy that guarantees a positive payoff in some contingency with no possibility of a negative payoff and with no net investment. By assumption, it is possible to run the arbitrage possibility at arbitrary scale; in other words, an arbitrage opportunity represents a money pump. A simple example of arbitrage is the opportunity to borrow and lend costlessly at two different fixed rates of interest. Such a disparity between the two rates cannot persist: arbitrageurs will drive the rate together.
It is not easy to separate the significance and influence of the Arrow-Debreu model of general equilibrium from that of mathematical economics itself. In an extraordinary series of papers (Arrow 1951; Debreu 1951; Arrow-Debreu 1954), two of the oldest and most important questions of neoclassical economics, the viability and efficiency of the market system, were shown to be susceptible to analysis in a model completely faithful to the neoclassical methodological premises of individual rationality, market clearing, and rational expectations, through arguments at least as elegant as any in economic theory, using the two techniques (convexity and fixed point theory) that are still, after thirty years, the most important mathematical devices in mathematical economics. Fifteen years after its birth (e.g. Arrow 1969), the model was still being reinterpreted to yield fresh economic insights, and twenty years later the same model was still capable of yielding new and fundamental mathematical properties (e.g. Debreu 1970, 1974). When we consider that the same two men who derived the most fundamental properties of the model (along with McKenzie 1954) also provided the most significant economic interpretations, it is no wonder that its invention has helped earn for each of its creators, in different years, the Nobel Prize for economics.
There has been growing interest in the field come to me known as “behavioral economics” which attempts to incorporate insights from other social sciences, especially psychology, in order to enrich the standard economic model. This interest the underlying psychology of human behavior returns economics to its earliest roots. Scholars such as Adam Smith talked about such key concepts as loss aversion, overconfidence, and self-control. Nevertheless, the modern version of behavioral economics introduced in the 1980s met with resistance by some economists, who preferred to retain the standard neo-classical model. They introduced several arguments for why psychology could safely be ignored. In this essay I show that these arguments have been rejected, both theoretically and empirically, so it is time to move on. The new approach to economics should include two different kinds of theories: normative models that characterize the optimal solution to specific problems and descriptive models that capture how humans actually behave. The latter theories will incorporate some variables I call supposedly irrelevant factors. By adding these factors such as framing or temptation we can improve the explanatory power of economic models. If everyone includes all the factors that do determine economic behavior, then the field of behavioral economics will no longer need to exist.
This article shows that global capital markets cannot, by themselves, achieve net transfers of financial capital between countries and that both the integration of global financial markets and the integration of global goods markets are needed to achieve net transfers of capital between countries. Frictions (barriers to mobility) in one or both of these markets can impede net transfers of capital between countries, produce the Feldstein and Horioka (1980) results and prevent real interest rates from being equalized across countries. Moreover, there is empirical evidence that barriers to the mobility of goods and services are an important obstacle to international capital mobility.
The recent global financial crisis has made the inadequacies of the scientific state of economics and finance glaringly obvious, as these disciplines gave the false reassurance that such a self-destructive phenomenon could not happen. A similar phenomenon arose in the 1930's, when the pitfalls of the dominant economic theories were sharply exposed. Since then, the same analytical framework, in its new versions, has revealed a huge number of other empirical and experimental failures. On the other hand, the founders of the currently dominant theories in economics and finance (i.e. the standard paradigm) such as Walras (1834-1910), Modigliani (1918-2003) and Miller (1923-2000) have identified mathematical contradictions within their own foundational models, the root cause of which no one has yet discovered. The standard paradigm has thus lost the reason for its existence in the light of experience, experiments and logical rigour. This book identifies the heuristic cause of these external and internal contradictions of the standard paradigm and remedies these problems by offering a new paradigm which can explain and predict observed economic behaviour, and resolve the extant behavioural, empirical and experimental puzzles. The new paradigm offers a dramatically improved understanding of economic behaviour at the micro as well as macro level of the economy within an over-arching framework comprising the real and the financial sectors. It does so in a rigorous but simple and clear way, using an axiomatic approach. It also offers policy recommendations on how the economy should be managed to avoid severe swings. It therefore is of great interest to scholars and practitioners in economics and finance.
This chapter discusses the production function and the theory of capital. The dominance in neo-classical economic teaching of the concept of a production function has had an enervating effect upon the development of the subject. The neo-classical system is based on the postulate that, in the long run, the rate of real wages tends to be such that all available labor is employed. In spite of the atrocities that have been committed in its name, there is a solid core of sense in this proposition. The condition that the given amount of capital employs the given amount of labor entails a particular rate of profit. But the value of the stock of concrete capital goods is affected by this rate of profit and the amount of capital that was started with cannot be defined independently of it.
Over two decades ago, Mehra and Prescott (1985) challenged the finance profession with a poser: the historical US equity premium is an order of magnitude greater than can be rationalized in the context of the standard neoclassical paradigm of financial economics. This regularity, dubbed “the equity premium puzzle,” has spawned a plethora of research efforts to explain it away. In this review, the author takes a retrospective look at the original paper and explains the conclusion that the equity premium is not a premium for bearing non-diversifiable risk.
When trade takes time, there are systematic deviations of the exchange rate from its Law of One Price value; these depend on the real interest rate in terms of the importable good. There is no systematic tendency for the spot rate to attain its LOP value in the long run. This means that agents in different countries price the same cash flows by using different risk premia, with agents in the ‘foreign’ country pricing the asset by adding a risk premium related to foreign exchange risk.
Restrictions that a class of general equilibrium models place upon the average returns of equity and Treasury bills are found to be strongly violated by the U.S. data in the 1889–1978 period. This result is robust to model specification and measurement problems. We conclude that, most likely, an equilibrium model which is not an Arrow-Debreu economy will be the one that simultaneously rationalizes both historically observed large average equity return and the small average risk-free return.
There is a general consensus that forward exchange rates have little if any power as forecasts of future spot exchange rates. There is less agreement on whether forward rates contain time varying premiums. Conditional on the hypothesis that the forward market is efficient or rational, this paper finds that both components of forward rates vary through time. Moreover, most of the variation in forward rates is variation in premium, and the premium and expected future spot rate components of forward rates are negatively correlated.
Aside from possible income effects, measures of the maximum amounts people will pay to avoid a loss and the minimum compensation
necessary for them to accept it are generally assumed to be equivalent. Unexpectedly wide variations between these sums, however,
have been noted in survey responses to hypothetical options. This paper reports the results of a series of experiments that
confronted people with actual money payments and cash compensations. The results indicate that the compensation measure of
value seems to exceed significantly the willingness to pay measure, which would appear to call into some question various
rules of entitlement, damage assessments, and interpretations of indifference curves.
We develop a new version of prospect theory that employs cumulative rather than separable decision weights and extends the theory in several respects. This version, called cumulative prospect theory, applies to uncertain as well as to risky prospects with any number of outcomes, and it allows different weighting functions for gains and for losses. Two principles, diminishing sensitivity and loss aversion, are invoked to explain the characteristic curvature of the value function and the weighting functions. A review of the experimental evidence and the results of a new experiment confirm a distinctive fourfold pattern of risk: risk aversion for gains and risk seeking for losses of high probability; risk seeking for gains and risk aversion for losses of low probability. Copyright 1992 by Kluwer Academic Publishers
Analysis of decision making under risk has been dominated by expected utility theory, which generally accounts for people's actions. Presents a critique of expected utility theory as a descriptive model of decision making under risk, and argues that common forms of utility theory are not adequate, and proposes an alternative theory of choice under risk called prospect theory. In expected utility theory, utilities of outcomes are weighted by their probabilities. Considers results of responses to various hypothetical decision situations under risk and shows results that violate the tenets of expected utility theory. People overweight outcomes considered certain, relative to outcomes that are merely probable, a situation called the "certainty effect." This effect contributes to risk aversion in choices involving sure gains, and to risk seeking in choices involving sure losses. In choices where gains are replaced by losses, the pattern is called the "reflection effect." People discard components shared by all prospects under consideration, a tendency called the "isolation effect." Also shows that in choice situations, preferences may be altered by different representations of probabilities. Develops an alternative theory of individual decision making under risk, called prospect theory, developed for simple prospects with monetary outcomes and stated probabilities, in which value is given to gains and losses (i.e., changes in wealth or welfare) rather than to final assets, and probabilities are replaced by decision weights. The theory has two phases. The editing phase organizes and reformulates the options to simplify later evaluation and choice. The edited prospects are evaluated and the highest value prospect chosen. Discusses and models this theory, and offers directions for extending prospect theory are offered. (TNM)
How internationally mobile is the world's supply of capital? Does capital flow among industrial countries to equalize the yield to investors? Alternatively, does the saving that originates in a country remain 'to be invested there? Or does the truth lie somewhere between these two extremes? The answers to these questions are not only important for understanding the international capital market but are also critical for analyzing a wide range of issues including the nation's optimal rate of saving and the incidence of tax changes. (This abstract was borrowed from another version of this item.)
Textbook arbitrage in financial markets requires no capital and entails no risk. In reality, almost all arbitrage requires capital and is typically risky. Moreover, professional arbitrage is conducted by a relatively small number of highly specialized investors using other people's capital. Such professional arbitrage has a number of interesting implications for security pricing, including the possibility that arbitrage becomes ineffective in extreme circumstances when prices diverge far from fundamental values. The model also suggests where anomalies in financial markets are likely to appear, and why arbitrage fails to eliminate them. Copyright 1997 by American Finance Association.
Observed preference reversal cannot be adequately explained by violations of independence, the reduction axiom, or transitivity. The primary cause of preference reversal is the failure of procedure invariance, especially the overpricing of low-probability, high-payoff bets. This result violates regret theory and generalized (nonindependent) utility models. Preference reversal and a new reversal involving time preferences are explained by scale compatibility, which implies that payoffs are weighted more heavily in pricing than in choice. Copyright 1990 by American Economic Association.
Money and the Real World
- Paul Davidson
The Theory of Interest
- Irving Fisher
On the Internal Contradictions of the Law of One Price
- F S Mcchesney
- W F Shughart
- D D Haddock
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