Abstract

http://ssrn.com/abstract=965128
 
 

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Stocks as Lotteries: The Implications of Probability Weighting for Security Prices


Nicholas Barberis


Yale School of Management; National Bureau of Economic Research (NBER)

Ming Huang


Cornell University - Samuel Curtis Johnson Graduate School of Management

February 2007

NBER Working Paper No. w12936

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.

Number of Pages in PDF File: 50

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Date posted: February 24, 2007  

Suggested Citation

Barberis, Nicholas and Huang, Ming, Stocks as Lotteries: The Implications of Probability Weighting for Security Prices (February 2007). NBER Working Paper No. w12936. Available at SSRN: http://ssrn.com/abstract=965128

Contact Information

Nicholas Barberis (Contact Author)
Yale School of Management ( email )
135 Prospect Street
P.O. Box 208200
New Haven, CT 06520-8200
United States
203-436-0777 (Phone)
National Bureau of Economic Research (NBER)
1050 Massachusetts Avenue
Cambridge, MA 02138
United States
Ming Huang
Cornell University - Samuel Curtis Johnson Graduate School of Management ( email )
Ithaca, NY 14853
United States
607-225-9594 (Phone)
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