On the Optimal Type and Level of Guarantees for Prospect Theory Investors

Abstract

It is well known that cumulative prospect theory (CPT) can explain a demand for guarantees in investment products. This observation motivates us to study what type of guarantee observed in real–world insurance markets is most attractive to CPT investors. We find that CPT investors favor a simple terminal wealth guarantee compared to more complex ratchet and cliquet guarantees. To obtain this result we determine the optimal specifications of these contracts to CPT investors by means of an extensive simulation study. Optimization further allows to study the desired guarantee level (which is determined endogeneously from preferences), and illustrates what elements of CPT drive the demand for guarantees. CPT investors either desire a guarantee level equal to their reference point or insurance against large losses only. Such a crash insurance can be explained by probability weighting alone, i.e., even in the absence of loss aversion.