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Loss aversion and the price of risk

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  • M. Levy
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    Abstract

    This paper derives a simple theoretical relationship between the degree of loss aversion, the concavity/convexity of the value function, and the equilibrium market price of risk. We show that while the degree of loss aversion is key in determining the market price of risk, the convexity/concavity of the value function is much less important in this respect. The theoretical relationship obtained is tested empirically by using international data from 16 different countries during over 100 years, as documented by Dimson et al. [Triumph of the Optimists: 101 Years of Global Investment Returns, 2002 (Princeton University Press)]. The empirical data yield an estimate of λ=2.3 for the loss aversion index. This value is in striking agreement with estimates obtained in the very different methodology of laboratory experiments of individual decision-making.

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    File URL: http://www.tandfonline.com/doi/abs/10.1080/14697680903059416
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    Bibliographic Info

    Article provided by Taylor & Francis Journals in its journal Quantitative Finance.

    Volume (Year): 10 (2010)
    Issue (Month): 9 ()
    Pages: 1009-1022

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    Handle: RePEc:taf:quantf:v:10:y:2010:i:9:p:1009-1022

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    Web page: http://www.tandfonline.com/RQUF20

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    Related research

    Keywords: Loss aversion; Economics of risk; Finance; Capital asset pricing;

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    Cited by:
    1. Li, Yan & Yang, Liyan, 2013. "Prospect theory, the disposition effect, and asset prices," Journal of Financial Economics, Elsevier, vol. 107(3), pages 715-739.

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