Probability weighting and loss aversion in futures hedging

Abstract

We analyze how the introduction of probability weighting and loss aversion in a futures hedging model affects decision making. Analytical findings indicate that probability weighting alone always affects optimal hedge ratios, while loss and risk aversion only have an impact when probability weighting exists. In the presence of probability weighting, simulation results for a relevant range of parameter values suggest that probability weighting is dominant; changes in probability weighting affect hedge ratios relatively more than changes in loss and risk aversion. When decisions are made independently, loss aversion has a relatively small impact on hedge ratios for all parameter values, and risk aversion becomes important for only a narrow range of risk coefficients which produce implausible speculative behavior. When prior losses and gains affect behavior, hedging is influenced most by prior outcomes that influence risk attitudes, but this effect is still somewhat less than the consequences of changes in probability weighting.