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Stochastic Dominance and Cumulative Prospect Theory

Manel Baucells () and Franz H. Heukamp ()
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No 201061, Working Papers from Fundacion BBVA / BBVA Foundation

Abstract: We generalize and extend the second order stochastic dominance condition available for Expected Utility to Cumulative Prospect Theory. The new definitions include, among others, preferences represented by S-shaped value and inverse S-shaped probability weighting functions. The stochastic dominance conditions supply a framework to test different features of Cumulative Prospect Theory. In the experimental part of the working paper we offer a test of several joint hypotheses on the value function and the probability weighting function. Assuming empirically relevant weighting functions, we can reject the inverse S-shaped value function recently advocated by Levy and Levy (2002a), in favor of the S-shaped form. In addition, we find generally supporting evidence for loss aversion. Violations of loss aversion can be linked to subjects using the overall probability of winning as heuristic.

Keywords: Second order stochastic dominance; cumulative prospect theory; value function; probability weighting function. (search for similar items in EconPapers)
Pages: 44
Date: 2007-01
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