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Prospect theory, the disposition effect, and asset prices

  • Li, Yan
  • Yang, Liyan
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    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.

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    File URL: http://www.sciencedirect.com/science/article/pii/S0304405X12002371
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    Article provided by Elsevier in its journal Journal of Financial Economics.

    Volume (Year): 107 (2013)
    Issue (Month): 3 ()
    Pages: 715-739

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    Handle: RePEc:eee:jfinec:v:107:y:2013:i:3:p:715-739
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/505576

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