Expected Utility, Prospect Theory and Asset Pricing

Abstract:     
Investors base asset valuation decisions on current day movements in asset and market returns. This is shown in the risk-return relationship of the simple asset pricing model using a four-way partition of daily returns. The partitioning is derived from current movements in individual asset and market returns. The underlying behavioral theory is a valuation framework that generalizes von Neumann-Morgenstern expected utility and allows for some commonly observed anomalies. We test key elements of Kahneman and Tversky's (1979) prospect theory and find reference dependence, asymmetric valuation of gains and losses, and nonproportional marginal sensitivity to large changes in expected returns in 1986-2000 data for 100 companies: the Dow-Jones 30 industrials and 30 and 40 companies selected at random from the S&P mid cap and small cap index lists respectively.

Number of Pages in PDF File: 59

Keywords: Behavioral finance, prospect theory, asset pricing, expected utility hypothesis, efficient market hypothesis, reference dependence, state-based conditional decisions

JEL Classification: D8, G1

working papers series