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Prospect Theory and the CAPM: A contradiction or coexistence?

  • Haim Levy
  • Enrico De Giorgi
  • Thorsten Hens

Under the assumption of normally distributed returns, we analyze whether the Cumulative Prospect Theory of Tversky and Kahneman (1992) is consistent with the Capital Asset Pricing Model. We find that in every financial market equilibrium the Security Market Line Theorem holds. However, under the specific functional form suggested by Tversky and Kahneman (1992) financial market equilibria do not exist. We suggest an alternative functional form that is consistent with both, the experimental results of Tversky and Kahneman and also with the existence of equilibria.

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Paper provided by Institute for Empirical Research in Economics - University of Zurich in its series IEW - Working Papers with number 157.

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Handle: RePEc:zur:iewwpx:157
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  1. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
  2. Ravi Jagannathan & Zhenyu Wang, 1996. "The conditional CAPM and the cross-section of expected returns," Staff Report 208, Federal Reserve Bank of Minneapolis.
  3. Meyer, Jack, 1987. "Two-moment Decision Models and Expected Utility Maximization," American Economic Review, American Economic Association, vol. 77(3), pages 421-30, June.
  4. Benartzi, Shlomo & Thaler, Richard H, 1995. "Myopic Loss Aversion and the Equity Premium Puzzle," The Quarterly Journal of Economics, MIT Press, vol. 110(1), pages 73-92, February.
  5. Tversky, Amos & Kahneman, Daniel, 1992. " Advances in Prospect Theory: Cumulative Representation of Uncertainty," Journal of Risk and Uncertainty, Springer, vol. 5(4), pages 297-323, October.
  6. Nicholas Barberis & Ming Huang & Tano Santos, . "Prospect Theory and Asset Prices," CRSP working papers 494, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  7. Michael Magill & Martine Quinzii, 2002. "Theory of Incomplete Markets, Volume 1," MIT Press Books, The MIT Press, edition 1, volume 1, number 0262632543, June.
  8. James Tobin, 1956. "Liquidity Preference as Behavior Towards Risk," Cowles Foundation Discussion Papers 14, Cowles Foundation for Research in Economics, Yale University.
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