Prospect theoryProspect theory is a theory of behavioral economics and behavioral finance that was developed by Daniel Kahneman and Amos Tversky in 1979. The theory was cited in the decision to award Kahneman the 2002 Nobel Memorial Prize in Economics. Based on results from controlled studies, it describes how individuals assess their loss and gain perspectives in an asymmetric manner (see loss aversion). For example, for some individuals, the pain from losing 1,000couldonlybecompensatedbythepleasureofearning2,000. Risk aversionIn economics and finance, risk aversion is the tendency of people to prefer outcomes with low uncertainty to those outcomes with high uncertainty, even if the average outcome of the latter is equal to or higher in monetary value than the more certain outcome. Risk aversion explains the inclination to agree to a situation with a more predictable, but possibly lower payoff, rather than another situation with a highly unpredictable, but possibly higher payoff.
Expected utility hypothesisThe expected utility hypothesis is a popular concept in economics that serves as a reference guide for decision making when the payoff is uncertain. The theory describes which options rational individuals should choose in a situation with uncertainty, based on their risk aversion. The expected utility hypothesis states an agent chooses between risky prospects by comparing expected utility values (i.e. the weighted sum of adding the respective utility values of payoffs multiplied by their probabilities).
Algorithmic tradingAlgorithmic trading is a method of executing orders using automated pre-programmed trading instructions accounting for variables such as time, price, and volume. This type of trading attempts to leverage the speed and computational resources of computers relative to human traders. In the twenty-first century, algorithmic trading has been gaining traction with both retail and institutional traders. A study in 2019 showed that around 92% of trading in the Forex market was performed by trading algorithms rather than humans.
Electronic trading platformIn finance, an electronic trading platform also known as an online trading platform, is a computer software program that can be used to place orders for financial products over a network with a financial intermediary. Various financial products can be traded by the trading platform, over a communication network with a financial intermediary or directly between the participants or members of the trading platform.
Regret (decision theory)In decision theory, on making decisions under uncertainty—should information about the best course of action arrive after taking a fixed decision—the human emotional response of regret is often experienced, and can be measured as the value of difference between a made decision and the optimal decision. The theory of regret aversion or anticipated regret proposes that when facing a decision, individuals might anticipate regret and thus incorporate in their choice their desire to eliminate or reduce this possibility.
Decision theoryDecision theory (or the theory of choice; not to be confused with choice theory) is a branch of applied probability theory and analytic philosophy concerned with the theory of making decisions based on assigning probabilities to various factors and assigning numerical consequences to the outcome. There are three branches of decision theory: Normative decision theory: Concerned with the identification of optimal decisions, where optimality is often determined by considering an ideal decision-maker who is able to calculate with perfect accuracy and is in some sense fully rational.
Hyperbolic absolute risk aversionIn finance, economics, and decision theory, hyperbolic absolute risk aversion (HARA) refers to a type of risk aversion that is particularly convenient to model mathematically and to obtain empirical predictions from. It refers specifically to a property of von Neumann–Morgenstern utility functions, which are typically functions of final wealth (or some related variable), and which describe a decision-maker's degree of satisfaction with the outcome for wealth. The final outcome for wealth is affected both by random variables and by decisions.
Endowment effectIn psychology and behavioral economics, the endowment effect (also known as divestiture aversion and related to the mere ownership effect in social psychology) is the finding that people are more likely to retain an object they own than acquire that same object when they do not own it. The endowment theory can be defined as "an application of prospect theory positing that loss aversion associated with ownership explains observed exchange asymmetries." This is typically illustrated in two ways.
NeuroeconomicsNeuroeconomics is an interdisciplinary field that seeks to explain human decision-making, the ability to process multiple alternatives and to follow through on a plan of action. It studies how economic behavior can shape our understanding of the brain, and how neuroscientific discoveries can guide models of economics. It combines research from neuroscience, experimental and behavioral economics, and cognitive and social psychology.
Behavioral economicsBehavioral economics studies the effects of psychological, cognitive, emotional, cultural and social factors in the decisions of individuals or institutions, and how these decisions deviate from those implied by classical economic theory. Behavioral economics is primarily concerned with the bounds of rationality of economic agents. Behavioral models typically integrate insights from psychology, neuroscience and microeconomic theory. The study of behavioral economics includes how market decisions are made and the mechanisms that drive public opinion.
Reinforcement learningReinforcement learning (RL) is an area of machine learning concerned with how intelligent agents ought to take actions in an environment in order to maximize the notion of cumulative reward. Reinforcement learning is one of three basic machine learning paradigms, alongside supervised learning and unsupervised learning. Reinforcement learning differs from supervised learning in not needing labelled input/output pairs to be presented, and in not needing sub-optimal actions to be explicitly corrected.
Loss aversionLoss aversion is a psychological and economic concept which refers to how outcomes are interpreted as gains and losses where losses are subject to more sensitivity in people's responses compared to equivalent gains acquired. Kahneman and Tversky (1992) have suggested that losses can be twice as powerful, psychologically, as gains. When defined in terms of the utility function shape as in the Cumulative Prospect Theory (CPT), losses have a steeper utility than gains, thus being more "painful" than the satisfaction from a comparable gain as shown in Figure 1.
RiskIn simple terms, risk is the possibility of something bad happening. Risk involves uncertainty about the effects/implications of an activity with respect to something that humans value (such as health, well-being, wealth, property or the environment), often focusing on negative, undesirable consequences. Many different definitions have been proposed. The international standard definition of risk for common understanding in different applications is "effect of uncertainty on objectives".
Automated trading systemAn automated trading system (ATS), a subset of algorithmic trading, uses a computer program to create buy and sell orders and automatically submits the orders to a market center or exchange. The computer program will automatically generate orders based on predefined set of rules using a trading strategy which is based on technical analysis, advanced statistical and mathematical computations or input from other electronic sources. These automated trading systems are mostly employed by investment banks or hedge funds, but are also available to private investors using simple online tools.
Equity premium puzzleThe equity premium puzzle refers to the inability of an important class of economic models to explain the average equity risk premium (ERP) provided by a diversified portfolio of U.S. equities over that of U.S. Treasury Bills, which has been observed for more than 100 years. There is a significant disparity between returns produced by stocks compared to returns produced by government treasury bills. The equity premium puzzle addresses the difficulty in understanding and explaining this disparity.
PreferenceIn psychology, economics and philosophy, preference is a technical term usually used in relation to choosing between alternatives. For example, someone prefers A over B if they would rather choose A than B. Preferences are central to decision theory because of this relation to behavior. Some methods such as Ordinal Priority Approach use preference relation for decision-making. As connative states, they are closely related to desires.
Delayed gratificationDelayed gratification, or deferred gratification, is the resistance to the temptation of an immediate pleasure in the hope of obtaining a valuable and long-lasting reward in the long-term. In other words, delayed gratification describes the process that the subject undergoes when the subject resists the temptation of an immediate reward in preference for a later reward. Generally, delayed gratification is associated with resisting a smaller but more immediate reward in order to receive a larger or more enduring reward later.
High-frequency tradingHigh-frequency trading (HFT) is a type of algorithmic trading in finance characterized by high speeds, high turnover rates, and high order-to-trade ratios that leverages high-frequency financial data and electronic trading tools. While there is no single definition of HFT, among its key attributes are highly sophisticated algorithms, co-location, and very short-term investment horizons in trading securities. HFT uses proprietary trading strategies carried out by computers to move in and out of positions in seconds or fractions of a second.
Isoelastic utilityIn economics, the isoelastic function for utility, also known as the isoelastic utility function, or power utility function, is used to express utility in terms of consumption or some other economic variable that a decision-maker is concerned with. The isoelastic utility function is a special case of hyperbolic absolute risk aversion and at the same time is the only class of utility functions with constant relative risk aversion, which is why it is also called the CRRA utility function.
