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An Axiomatization of Linear Cumulative Prospect Theory with Applications to Portfolio Selection and Insurance Demand

By Ulrich Schmidt A and Horst Zank (ye B

Abstract

Abstract. The present paper combines loss attitudes and linear utility by providing an axiomatic analysis of corresponding preferences in a cumulative prospect theory (CPT) framework. (CPT) is one of the most promising alternatives to expected utility theory since it incorporates loss aversion, and linear utility for money receives increasing attention since it is often concluded in empirical research, and employed in theoretical applications. Rabin (2000) emphasizes the importance of linear utility, and highlights loss aversion as an explanatory feature for the disparity of significant small-scale risk aversion and reasonable large-scale risk aversion. In a sense we derive a two-sided variant of Yaari’s dual theory, i.e. nonlinear probability weights in the presence of linear utility. The first important difference is that utility may have a kink at the status quo, which allows for the exhibition of loss aversion. Also, we may have different probability weighting functions for gains than for losses. The central condition of our model is termed independence of common increments. The applications of our model to portfolio selection an

Topics: cumulative prospect theory, insurance demand, linear utility, loss aversion, portfolio selection, risk aversion. Journal of Economic Literature Classification Numbers
Year: 2002
OAI identifier: oai:CiteSeerX.psu:10.1.1.319.1470
Provided by: CiteSeerX
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