Abstract

http://ssrn.com/abstract=2070910
 
 

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Prospect Theory and the Risk-Return Trade-off


Huijun Wang


University of Delaware

Jinghua Yan


SAC Capital Advisors; University of Pennsylvania - Wharton Financial Institutions Center

Jianfeng Yu


University of Minnesota

January 2014


Abstract:     
This paper studies the cross-sectional risk-return trade-off in the stock market, a fundamental principle in finance. This tenet posits a positive relation between risk and expected return, whereas recent empirical evidence suggests that low-risk firms tend to earn higher average returns. We apply prospect theory to shed light on this violation of a fundamental principle in finance. Prospect theory posits that when facing prior loss relative to a reference point, individuals tend to be risk seeking rather than risk averse. Consequently, among stocks where investors face prior losses, there could be a negative risk-return relation. By contrast, among stocks where investors face capital gains, the traditional positive risk-return relation should emerge, since investors of these stocks are risk averse. Using several intuitive measures of risk, we provide consistent empirical support for our hypotheses.

Number of Pages in PDF File: 53

Keywords: Prospect Theory, Risk-Return Trade-Off, Mental Accounting, Beta, Risk, Uncertainty

JEL Classification: G02, G12, G14

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Date posted: May 30, 2012 ; Last revised: January 18, 2014

Suggested Citation

Wang, Huijun and Yan, Jinghua and Yu, Jianfeng, Prospect Theory and the Risk-Return Trade-off (January 2014). Available at SSRN: http://ssrn.com/abstract=2070910 or http://dx.doi.org/10.2139/ssrn.2070910

Contact Information

Huijun Wang
University of Delaware ( email )
B & E Finance, UD
306 Purnell Hall
NEWARK, DE Delaware 19716
United States
Jinghua Yan
SAC Capital Advisors ( email )
330 Madison Avenue, 35th Floor
New York, NY 10017
United States
University of Pennsylvania - Wharton Financial Institutions Center ( email )
2306 Steinberg Hall-Dietrich Hall
3620 Locust Walk
Philadelphia, PA 19104
United States
Jianfeng Yu (Contact Author)
University of Minnesota ( email )
321 19th Avenue
Suite 3-122
Minneapolis, MN 55455
United States
HOME PAGE: http://users.cla.umn.edu/~jianfeng/
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