The assumptions concerning the shape of utility functions of investors differ between conventional theory and prospect theory. Conventional theory assumes that utility functions are __________, whereas prospect theory assumes that utility functions are __________.
A) concave and defined in terms of wealth; s-shaped (convex to losses and concave to gains) and defined in terms of losses relative to current wealth
B) convex and defined in terms of losses relative to current wealth; s-shaped (convex to losses and concave to gains) and defined in terms of losses relative to current wealth
C) s-shaped (convex to losses and concave to gains) and defined in terms of losses relative to current wealth; concave and defined in terms of wealth
D) s-shaped (convex to losses and concave to gains) and defined in terms of wealth; concave and defined in terms of losses relative to current wealth
E) convex and defined in terms of wealth; concave and defined in terms of gains relative to current wealth

Question

Quizplus · Accepted Answer

Conventional theory typically assumes utility functions are concave and defined in terms of wealth, reflecting risk aversion. Prospect theory, on the other hand, suggests utility functions are s-shaped (convex to losses and concave to gains) and defined in terms of changes (gains or losses) relative to current wealth, capturing different attitudes towards gains versus losses.

The Assumptions Concerning the Shape of Utility Functions of Investors