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

Enrico De Giorgi, Thorsten Hens & Haim Levy

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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.
   
type journal paper
   
keywords asset pricing;cumulative prospect theory;capital asset pricing model;equilibrium
   
project Applying Recent Developments in Computational Statistics to Behavioral Asset Pricing and Portfolio Selection
language English
kind of paper journal article
date of appearance 3-2012
journal European Financial Management
publisher Wiley-Blackwell (Oxford UK)
ISSN 1354-7798
ISSN (online) 1468-036X
DOI 10.1111/j.1468-036X.2011.00617.x
volume of journal 18
number of issue 2
page(s) 163-182
review double-blind review
   
profile area SEPS - Quantitative Economic Methods
citation De Giorgi, E., Hens, T., & Levy, H. (2012). Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?. European Financial Management, 18(2), 163-182, DOI:10.1111/j.1468-036X.2011.00617.x.