Second Order Stochastic Dominance, Reward-Risk Portfolio Selection and the CAPM
Journal
Journal of Financial and Quantitative Analysis
ISSN
0022-1090
Type
journal article
Date Issued
2008-06-01
Author(s)
Abstract
Starting from the reward-risk model for portfolio selection introduced in De Giorgi (2005), we derive the reward-risk Capital Asset Pricing Model (CAPM) analogously to the classical mean-variance CAPM. In contrast to the mean-variance model, reward-risk portfolio selection arises from an axiomatic definition of reward and risk measures based on a few basic principles, including consistency with second-order stochastic dominance. With complete markets, we show that at any financial market equilibrium, reward-risk investors' optimal allocations are comonotonic and, therefore, our model reduces to a representative investor model. Moreover, the pricing kernel is an explicitly given, non-increasing function of the market portfolio return, reflecting the representative investor's risk attitude. Finally, an empirical application shows that the reward-risk CAPM captures the cross section of U.S. stock returns better than the mean-variance CAPM does.
Language
English
HSG Classification
contribution to scientific community
Refereed
Yes
Publisher
University of Washington School of Business Administration
Publisher place
Seattle, Wash.
Volume
43
Number
2
Start page
525
End page
546
Pages
22
Subject(s)
Eprints ID
51194