PROSPECT THEORY AND MAX EFFECT: AN EMPIRICAL ANALYSIS

Abstract

How individuals evaluate risk and make investment decisions in risky and uncertain situations has always been the center point of debate in the financial markets literature (Barberis et al., 2016; Benartzi & Thaler, 1995; Tversky & Kahneman, 1974). Conventionally, academic literature has often employed expected utility theory (EUT) and models of rational equilibrium with adjustments for behavioural biases to model this individual investment decision-making process. However, in modern electronic markets with a plethora of investment choices and voluminous trading activity by retail investors, considerable evidence has become available that investors do not conform to EUT and models of rational equilibrium (Barberis et al., 2016; Chen et al., 2022). More recently, an alternative construct of individual decision-making, namely the prospect theory (PT) model of choice, has been adopted from the area of behavioural psychology (Kahneman & Tversky, 1979; Tversky & Kahneman, 1992). Motivated by that, past literature has widely studied behaviour biases present in investors, especially the impact of preference for extreme returns and investor sentiments on asset pricing of asset classes like stocks, options/futures, mutual funds, etc., especially in developed markets at great length. To this end, our thesis is a collection of three studies that provide new behavioural insights into the pricing of two significant asset classes, equities, and cryptocurrencies (CC or CCs).