Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?

20 Pages Posted: 17 Mar 2012

See all articles by Haim Levy

Haim Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration; Fordham University

Enrico G. De Giorgi

University of St. Gallen - SEPS: Economics and Political Sciences

Thorsten Hens

University of Zurich - Department of Banking and Finance; Norwegian School of Economics and Business Administration (NHH); Swiss Finance Institute

Multiple version iconThere are 2 versions of this paper

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

Levy, Haim and De Giorgi, Enrico G. and Hens, Thorsten, Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence? (March 2012). European Financial Management, Vol. 18, Issue 2, pp. 163-182, 2012. Available at SSRN: https://ssrn.com/abstract=2025289 or http://dx.doi.org/10.1111/j.1468-036X.2011.00617.x

Haim Levy

Hebrew University of Jerusalem - Jerusalem School of Business Administration ( email )

Mount Scopus
Jerusalem, 91905
Israel

HOME PAGE: http://pluto.huji.ac.il/~mshlevy/

Fordham University ( email )

140 West 62nd Street
New York, NY 10023
United States

Enrico G. De Giorgi

University of St. Gallen - SEPS: Economics and Political Sciences ( email )

Department of Economics
Bodanstrasse 6
CH-9000 St. Gallen
Switzerland
+41712242430 (Phone)

Thorsten Hens

University of Zurich - Department of Banking and Finance ( email )

Plattenstrasse 32
Zurich, 8032
Switzerland
+41-44 634 37 06 (Phone)

Norwegian School of Economics and Business Administration (NHH)

Helleveien 30
Bergen, 5045
Norway

Swiss Finance Institute

c/o University of Geneva
40, Bd du Pont-d'Arve
CH-1211 Geneva 4
Switzerland

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