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Second-Order Stochastic Dominance, Reward-Risk Portfolio Selection, and the CAPM

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Author Info
De Giorgi, Enrico
Post, Thierry

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Abstract

Starting from the reward-risk model for portfolio selection introduced in De Giorgi (2005), we derive the reward-risk Capital Asset Pricing Model (CAPM) analogously to the classical mean-variance CAPM. In contrast to the mean-variance model, reward-risk portfolio selection arises from an axiomatic definition of reward and risk measures based on a few basic principles, including consistency with second-order stochastic dominance. With complete markets, we show that at any financial market equilibrium, reward-risk investors' optimal allocations are comonotonic and, therefore, our model reduces to a representative investor model. Moreover, the pricing kernel is an explicitly given, non-increasing function of the market portfolio return, reflecting the representative investor's risk attitude. Finally, an empirical application shows that the reward-risk CAPM captures the cross section of U.S. stock returns better than the mean-variance CAPM does.

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Publisher Info
Article provided by Cambridge University Press in its journal Journal of Financial and Quantitative Analysis.

Volume (Year): 43 (2008)
Issue (Month): 02 (June)
Pages: 525-546
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Handle: RePEc:cup:jfinqa:v:43:y:2008:i:02:p:525-546_00

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