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Stocks as Lotteries: The Implications of Probability Weighting for Security Prices

  • Nicholas Barberis
  • Ming Huang

We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with a particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with nonunique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be "overpriced" and can earn a negative average excess return. We argue that our analysis offers a unifying way of thinking about a number of seemingly unrelated financial phenomena. (JEL D81, G11, G12)

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.98.5.2066
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 98 (2008)
Issue (Month): 5 (December)
Pages: 2066-2100

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Handle: RePEc:aea:aecrev:v:98:y:2008:i:5:p:2066-2100
Note: DOI: 10.1257/aer.98.5.2066
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