New Open Access Paper: The Market’s Implied Loss Aversion under Power-Log Utility Investor Preferences

[jk...@stmarys-ca.edu]

Dear colleagues,

I’d like to share my recent paper published in Finance Research Letters.  It puts forth a testable hypothesis of prospect theory based on market data rather than experimental data, and it contradicts prospect theory’s convex value function for losses at the aggregate market level.

 Abstract:

We use the equilibrium between equity-index spot and options markets, investor preferences modeled with Power-Log utility functions, and utility indifference pricing to estimate the market’s implied loss aversion, and test prospect theory’s and cumulative prospect theory’s decreasing marginal sensitivity to losses postulate at the aggregate market level. We find that the equilibrium downside power in the Power-Log utility function is consistently and significantly negative, implying increasing marginal sensitivity and a concave utility function for losses. That contradicts prospect theory’s and cumulative prospect theory’s S-shaped value function at the aggregate market level.

Link to freely available full open access paper:

https://www.sciencedirect.com/science/article/pii/S1544612325004179

Feedback and discussion are very welcome.

Best regards,
Jiv Kale
Saint Mary's College of California