Prospect theory and liquidation decisions

We solve a liquidation problem for an agent with preferences consistent with the prospect theory of Kahneman and Tversky (1979). We find that the agent is willing to hold a risky project with a relatively inferior Sharpe ratio if the project is currently making losses, and intends to liquidate it when it breaks even. On the other hand, the agent may liquidate a project with a relatively superior Sharpe ratio if its current profits rise or drop to the break-even point. Our results capture the spirit of the disposition effect and the break-even effect documented in empirical and experimental studies. (JEL G39, G19, D81) ∗Kyle is with the Fuqua School of Business, Duke University, Durham, NC 27708. E-mail: [email protected]; Phone: (919) 660-7797. Ou-Yang is with the Fuqua School of Business, Duke University, Durham, NC 27708. E-mail: [email protected]; Phone: (919) 660-3790. Xiong is with the Department of Economics and Bendheim Center for Finance, Princeton University, Princeton, NJ 08540. E-mail: [email protected]; Phone: (609) 258-0282. We are grateful to two anonymous referees for offering many insightful suggestions and comments that have improved the paper significantly. We also thank seminar participants at the University of Virginia for helpful comments.