Stocks as Lotteries: the Implications of Probability Weighting for Security Prices
Yale School of Management; National Bureau of Economic Research (NBER)
Cornell University - Samuel Curtis Johnson Graduate School of Management
AFA 2005 Philadelphia Meetings Paper
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.
Number of Pages in PDF File: 49
Keywords: prospect theory, asset pricing, skewness, under-diversification
JEL Classification: D1, D8, G11, G12
Date posted: January 16, 2005
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