Prospect theory and the effectiveness of price limits

Mei Chen Lin, Pin Huang Chou

Research output: Contribution to journalArticlepeer-review

8 Scopus citations


Assuming that traders are risk-neutral, Brennan (1986) shows that price limits are effective in improving the efficiency of futures contracts with limited accessibility to information because they obscure the exact loss when they are triggered. However, Brennan's (1986) model fails to explain why price limits also exist in contracts with abundant information like those of financial futures. We show that when traders are loss-averse, the effectiveness of price limits is strengthened even in the presence of precise information. Thus, our analysis provides a theoretical foundation explaining why price limits can be useful when market participants are not fully rational.

Original languageEnglish
Pages (from-to)330-349
Number of pages20
JournalPacific Basin Finance Journal
Issue number3
StatePublished - Jun 2011


  • Default risk
  • Loss aversion
  • Margin requirement
  • Price limits


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