Working Paper: NBER ID: w12936
Authors: Nicholas Barberis; Ming Huang
Abstract: We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with non-unique 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. Our results offer a unifying way of thinking about a number of seemingly unrelated financial phenomena, such as the low average return on IPOs, private equity, and distressed stocks; the diversification discount; the low valuation of certain equity stubs; the pricing of out-of-the-money options; and the lack of diversification in many household portfolios.
Keywords: cumulative prospect theory; asset pricing; skewness; investor behavior
JEL Codes: D81; G11; G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Cumulative Prospect Theory (D81) | Positively Skewed Security is Overpriced (G12) |
| Positively Skewed Security is Overpriced (G12) | Negative Average Excess Return (C29) |
| Investors Overweight Tails of Distribution (G40) | Positively Skewed Security is Overpriced (G12) |
| Cumulative Prospect Theory (D81) | CAPM Holds Under Specific Conditions (G19) |
| Skewness (C46) | Pricing of Skewed Securities (G19) |
| Multiple Skewed Securities (G19) | Skewed Security's Pricing Influenced by Non-Unique Global Optima (D49) |