Prospect theory and the effectiveness of price limits

Mei-Chen Lin and Pin-Huang Chou

Pacific-Basin Finance Journal, 2011, vol. 19, issue 3, 330-349

Abstract: Assuming that traders are risk-neutral, Brennan (1986) shows that price limits are effective in improving the efficiency of futures contracts with limited accessibility to information because they obscure the exact loss when they are triggered. However, Brennan's (1986) model fails to explain why price limits also exist in contracts with abundant information like those of financial futures. We show that when traders are loss-averse, the effectiveness of price limits is strengthened even in the presence of precise information. Thus, our analysis provides a theoretical foundation explaining why price limits can be useful when market participants are not fully rational.

Keywords: Price; limits; Margin; requirement; Default; risk; Loss; aversion (search for similar items in EconPapers)
Date: 2011
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Citations: View citations in EconPapers (5)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:pacfin:v:19:y:2011:i:3:p:330-349

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