| This dissertation examines risky decisions in finance using prospect theory as an alternative to the more conventional von Neumann-Morgenstern expected utility theory. Prospect theory, developed by Kahnemann and Tversky (1979), attempts to explain the observed risk seeking tendencies and behavior of decision makers that violate the normative axioms of choice.; Three finance decisions are explored. First Ross (1976), Blazenko (1987) and others have shown that asymmetry of information available to managers and to investors imply the existence of a separating equilibrium capital structure. This dissertation expands upon the Blazenko work by applying prospect theory to the capital structure decision. Specifically it is shown that risk preferences represented by prospect theory imply that the issue of debt is not an unambiguous signal of quality. In the presence of asymmetric information, Kahnemann-Tversky type preferences yield differing implications for capital structure equilibrium.; Second, prospect theory is used to determine the role played by risk preferences in the analysis of well documented biases in the Black-Scholes option pricing model. The deviation of observed prices from arbitrage determined values, which can be explained in part due to investor risk preferences, is examined across deep out-of-the-money options. The deviations of call prices vary in a systematic manner in accordance with prospect theory.; Third, the classical portfolio selection model presumes that investors are globally risk averse. Observed risk seeking tendencies have implications for risk-return relationships in a mean-variance framework. A survey of business students and investment managers designed to elicit choice responses to risky alternatives provides an empirical test of the specific implications of prospect theory. It is found that prospect theory does not provide a better description of observed investor behavior.; Prospect theory has been developed as a more adequate descriptive theory of choice under conditions of risk than the von Neumann Morgenstern paradigm. This dissertation examines the efficacy of prospect theory in finance through the development of analytical and empirical tests of investor and managerial behavior. |
