Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?
20 Pages Posted: 17 Mar 2012
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Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?
Date Written: March 2012
Abstract
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) maximisation 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 maximise 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.
Keywords: asset pricing, cumulative prospect theory, capital asset pricing model, equilibrium
JEL Classification: C62, D51, D52, G11, G12
Suggested Citation: Suggested Citation
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Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?
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