Greed, Leverage, and Potential Losses: A Prospect Theory Perspective

Partly motivated by a deeper understanding of the role human greed has played in the current financial crisis, this paper quantifies the notion of greed, and explores its connection with leverage and potential losses, in the context of a continuoustime behavioral portfolio choice model under (cumulative) prospect theory. We We are grateful for comments from seminar and conference participants at Columbia, Nomura London, Paris Dauphine, University of Hong Kong, the 5th Oxford-Princeton Workshop on Financial Mathematics & Stochastic Analysis, the 4th General Conference on Advanced Mathematical Methods for Finance in Alesund, Norway, the 2009 Strategies and Risk Analysis International Conference in Bangkok, Thailand, the 2009 IIM International Finance Conference in Calcutta, India, the 2009 Quantitative Methods in Finance Conference in Sydney, Australia, and the 2010 International Conference on Actuarial and Financial Risks in Shanghai, China. In particular we thank Hersh Shefrin for illuminating comments on the notion of greed while this research was being carried out. Zhou owes thanks for aid to a start-up fund of the University of Oxford. The usual disclaimer applies. Mathematical Institute and Nomura Centre for Mathematical Finance, and Oxford–Man Institute of Quantitative Finance, The University of Oxford, 24–29 St Giles, Oxford OX1 3LB, UK. Email: . Mathematical Institute and Nomura Centre for Mathematical Finance, and Oxford–Man Institute of Quantitative Finance, The University of Oxford OX1 3LB, UK, and Department of Systems Engineering and Engineering Management, The Chinese University of Hong Kong, Shatin, Hong Kong. Email: .