THE FOSTER-HART OPERATIONAL MEASURE OF RISKINESS FOR GAMBLERS.

Abstract

In 2009, Foster and Hart proposed a measure of riskiness that comes with an “operational” aspect. Incorporating a critical wealth function, this framework hopes to aid users in avoiding bankruptcy by determine which gambles are not worth taking. Assuming the linearity of the utility function, this thesis paper aims to add to the existing literature by applying Prospect Theory developed by Kahneman and Tversky (1979) to Foster and Hart’s existing strategy with utility functions to determine an alternative critical wealth function. In particular, we will use the probability weighting functions introduced in Prospect Theory to determine if a simple strategy to avoid bankruptcy can be found. With the help of a simple index, it is found that there is an optimal level of distortion in probabilities where decision makers can accept a maximum number of gambles and avoid bankruptcy.