Working Paper: CEPR ID: DP17935
Authors: Xiang Gao; Kees Koedijk; Maurizio Montone; Zhan Wang
Abstract: We propose a Capital Asset Pricing Model where investors exhibit prospect preferences. In equilibrium, we find that agents seek an optimal trade-off between expected returns, variance, and skewness. All assets in the economy are then priced by a three-factor model, which augments the security market line with two factors that respectively capture positive and negative coskewness with the market portfolio. Using U.S. stock market data, we find evidence consistent with these predictions. In additional tests, we find that the results are stronger among stocks traded by less sophisticated investors. Overall, prospect preferences have a substantial effect on stock prices.
Keywords: prospect theory; stock returns; beta; pricing; skewness
JEL Codes: G11; G12; G14; G41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| prospect preferences (D11) | optimal tradeoff between expected returns, variance, and skewness (G11) |
| optimal tradeoff between expected returns, variance, and skewness (G11) | asset pricing in a three-factor model (G12) |
| coskewness (C10) | stock returns (G12) |
| positive coskewness (C10) | risk premium in the gains domain (G11) |
| negative coskewness (C10) | risk premium in the losses domain (G22) |
| investor sophistication (G11) | asset pricing (G19) |
| prospect preferences (D11) | stock prices (G12) |