Using Curvilinear Spline Regression To Empirically Test Relationships Predicted By Prospect Theory

Abstract

Prospect theory (Kahneman & Tversky, 1979) suggests that decision makers compare decision criteria against a reference point when evaluating alternatives. Specifically it posits that decision makers are risk-seeking for losses (below the reference point) and risk-averse for gains (above the reference point).  It further proposes that the degree of risk aversion above the reference point is greater than the risk seeking below it.  This theory has received widespread acceptance due to intuitive appeal and theoretical support.  However the theory does not have strong evidentiary support in actual practice because it is rarely empirically tested in non-experimental situations involving real market data.  Often the type or amount of data available does not lend itself to the examination of relationships posited by prospect theory, however even if he data is appropriate, difficulties may arise in modeling and testing.  In this paper, after a brief discussion of prospect theory and situations where it is applicable, we present an approach to the empirical testing of prospect theory predictions using curvilinear spline (piecewise polynomial) regression.  Among the issues addressed are adequacy of data, choice of inflection point, modeling the curves and hypothesis testing.