Resumen de Stochastic Dominance and Cumulative Prospect Theory

Manel Baucells, Franz H. Heukamp

• 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.