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Risk Aversion in Cumulative Prospect Theory

Department of Economics, Christian-Albrechts-Universität zu Kiel, 24098 Kiel, Germany and Kiel Institute for the World Economy, 24105 Kiel, Germany
Department of Economics, School of Social Sciences, University of Manchester, Manchester M13 9PL, United Kingdom
uschmidt{at}bwl.uni-kiel.de
horst.zank{at}manchester.ac.uk

This paper characterizes the conditions for strong risk aversion and second-order stochastic dominance for cumulative prospect theory. Strong risk aversion implies a convex weighting function for gains and a concave one for losses. It does not necessarily imply a concave utility function. The latter does follow if the weighting functions are continuous. By investigating the exact relationship between loss aversion and strong risk aversion, a natural index for the degree of loss aversion is derived.

Key Words: cumulative prospect theory; loss aversion; risk aversion; second-order stochastic dominance; decision analysis theory; risk
History: Received: November 16, 2005;

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