Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?
Enrico G. De Giorgi
University of St. Gallen - SEPS: Economics and Political Sciences
University of Zurich - Department of Banking and Finance; Norwegian School of Economics and Business Administration (NHH); Swiss Finance Institute (Zurich Center)
Hebrew University of Jerusalem - Jerusalem School of Business Administration; Fordham University
May 12, 2011
Markowitz and Sharpe won the Nobel Prize in Economics for the development of Mean-Variance (M-V) analysis and the Capital Asset Pricing Model (CAPM). Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. In deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU) maximization in the face of risk aversion. Kahneman and Tversky suggest Prospect Theory (PT) as an alternative paradigm to EU theory. They show that investors distort probabilities, make decisions based on change of wealth, exhibit loss aversion and maximize the expectation of an S-shaped value function, which contains a risk-seeking segment. Can these two apparently contradictory paradigms coexist? We show in this paper that although CPT (and PT) is in conflict to EUT, and violates some of the CAPM’s underlying assumptions, the Security Market Line Theorem (SMLT) of the CAPM is intact in the CPT framework. Therefore, the CAPM is intact also in CPT framework.
Number of Pages in PDF File: 32
Keywords: asset pricing, cumulative prospect theory, capital asset pricing model, equilibrium.
JEL Classification: C62, D51, D52, G11, G12.working papers series
Date posted: August 13, 2003 ; Last revised: May 15, 2011
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