Essay: Prospect theory

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  • Subject area(s): Finance essays
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  • Published on: September 17, 2015
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  • Prospect theory
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Prospect theory will always be defined as a behavioral economic theory that people value gains and losses and make decision which concerning on perceived gains rather than perceived losses as fundamental. According to journal of ‘Prospect Theory and Coercive Bargaining’ by author Christopher K. Butler, Prospect theory has been applied in order to solve the strategy issues of international conflict, negotiation, social dilemmas and litigation.
For international conflict, decision-theoretic approach to the strategic issue (Taber 1993; Gibbs 1996) is taken although mathematical analyses have included pseudocertainty and aversion. For social dilemmas, Brewer and Kramer (1986) has used the prospect theory concept of loss abomination to make argument that cooperation rates ought to be greater for ordinary dilemmas than for public merchandise issues. Nonetheless the argument does not make any pseudocertainty effect which refers to tendency of a person to perceive an output as certain while it is uncertain in reality
The study on the hypothesis of overreaction by De Bondt and Thaler (1985) was the earliest empirical researches. The study was dependent upon the thought that investors generally overreact to news events. This meaning that the stock value will then be determined excessively high by great news or excessively low by awful news. The stocks likewise be evaluated according to their residual returns. The stocks with higher residual returns were considered as winners and stocks with most minimal residual returns were considered as losers.
Besides, same study on this territory was conducted by Brown and Harlow (1988) after the De Bondt and Thaler’s study. They reported that price inversions were found after extreme price movement. Therefore, investors overreacted more to negative extreme price movement than to positive extreme price movement.
Lai, Guru and Nor (2003) inspected the overreaction hypothesis in Malaysia stock market by using month to month returns of all stocks recorded on the main board of the Kuala Lumpur Stock Exchange from 1987 to 1999. Their discovering likewise supported the overreaction hypothesis and presumed that the contrarian profits were mainly because of overreaction instead of firm size impact and time-varying risk.
References:
Christopher, K. B. (2007). Journal of Conflict Resolution. Prospect Theory and Coercive Bargaining, 51(2), 227-250.
Lam, K. M. (2009). ProQuest Dissertations and Theses. Overreaction in Asia-Pacific Index Future Markets.

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