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Prospect Theory and Risk-Seeking Behavior by Troubled Firms

Prospect Theory and Risk-Seeking Behavior by Troubled Firms

Journal of Behavioral Finance
Volume 12, Issue 1, 2011, pages 29-40

Doron Kligera & Iris Tsurb

Abstract

We employ Prospect Theory (PT, Kahneman and Tversky [1979]) to explain the relationship between risk and return at the organization level. Our modeling approach addresses shortcomings in previous research approaches. We suggest an alternative approach for inferring the reference point, a key element of PT, and measuring risk, as well as a different representation of the risk-return association taking into consideration a timeline of the firm’s state, its state dependent action, and consequences. Consistent with PT, results using COMPUSTAT data show that firms with returns above their reference levels take less risk than firms with returns below their reference levels.

Keywords : Prospect theory, Organization level, Reference point, Risk preferences, Strategic decision making

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