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Prospect theory, the disposition effect, and asset prices

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  • Li, Yan
  • Yang, Liyan

Abstract

We build a general equilibrium model to examine the implications of prospect theory for the disposition effect, asset prices, and trading volume. Diminishing sensitivity predicts a disposition effect, price momentum, a reduced return volatility, and a positive return-volume correlation. Loss aversion generally predicts the opposite. In calibrated economies, there is a nontrivial range of preference parameters for prospect theory to simultaneously explain the disposition effect, the momentum effect, and the equity premium puzzle. Our model is helpful for understanding a wide range of financial phenomena and it also suggests new testable predictions.

Suggested Citation

  • Li, Yan & Yang, Liyan, 2013. "Prospect theory, the disposition effect, and asset prices," Journal of Financial Economics, Elsevier, vol. 107(3), pages 715-739.
  • Handle: RePEc:eee:jfinec:v:107:y:2013:i:3:p:715-739
    DOI: 10.1016/j.jfineco.2012.11.002
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    More about this item

    Keywords

    Prospect theory; Disposition effect; Momentum; Reversal; Turnover;
    All these keywords.

    JEL classification:

    • G11 - Financial Economics - - General Financial Markets - - - Portfolio Choice; Investment Decisions
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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