Abstract
Expected utility theory (EUT) is one of the pillars of modern economics and finance. Investors are risk averse when considering prospects with only positive outcomes but are risk seeking when considering prospects with only negative outcomes. Investors systematically distort probabilities and base their decisions on their subjective probabilities, rather than on the objective probabilities. Prospect theory was inspired by experiments in which individuals were asked to state their certainty equivalents for risky prospects. In these experiments, the outcomes of the prospects were given in dollar terms. As a consequence, the theory was formulated in terms of change in wealth in dollars. The equilibrium price of the stock is determined by investors' portfolio optimization and by market clearance. The crossover between these two states is sharp—a small change in one of the rate of return distribution parameters may lead to a switch from one state to the other.
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