Now showing 1 - 10 of 36
  • Publication
    A Concave Security Market Line
    (Elsevier, ) ;
    Post, Thierry
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    Yalçın, Atakan
    We provide theoretical and empirical arguments in favor of a diminishing marginal premium for market risk. In capital market equilibrium with binding portfolio restrictions, investors with different risk aversion levels generally hold different sets of risky securities. Whereas the traditional linear relation breaks down, equilibrium can be described or approximated by a concave relation between expected return and market beta, and a concave relationship between market alpha and market beta. An empirical analysis of U.S. stock market data confirms the existence of a significant concave cross-sectional relation between average return and estimated market beta. We estimate that the market risk premium is at least four to six percent per annum, substantially above traditional estimates. A practical implication for active portfolio managers is that the alpha of ``betting against beta'' strategies seems dominated by the medium-minus-high-beta spread rather than the low-minus-medium-beta spread. The success of such strategies thus largely depends on underweighting or short selling high-beta stocks.
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  • Publication
    Diversification Preferences in the Theory of Choice
    (Springer Italia, 2016-11-11) ;
    Diversification represents the idea of choosing variety over uniformity. Within the theory of choice, desirability of diversification is axiomatized as preference for a convex combination of choices that are equivalently ranked. This corresponds to the notion of risk aversion when one assumes the von Neumann–Morgenstern expected utility model, but the equivalence fails to hold in other models. This paper analyzes axiomatizations of the concept of diversification and their relationship to the related notions of risk aversion and convex preferences within different choice theoretic models. Implications of these notions on portfolio choice are discussed. We cover model-independent diversification preferences, preferences within models of choice under risk, including expected utility theory and the more general rank-dependent expected utility theory, as well as models of choice under uncertainty axiomatized via Choquet expected utility theory. Remarks on interpretations of diversification preferences within models of behavioral choice are given in the conclusion.
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    Scopus© Citations 6
  • Publication
    Monetary policy regimes: implications for the yield curve and bond pricing
    (Elsevier, 2014-09-01)
    Filipova, Kameliya
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    We develop a multivariate dynamic term structure model, which takes into account the nonlinear (time-varying) relationship between interest rates and the state of the economy. In contrast to the classical term structure literature, where nonlinearities are captured by increasing the number of latent state variables, or by latent regime shifts, in our no-�arbitrage framework the regimes are governed by thresholds and are directly linked to economic fundamentals. Specifically, starting from a simple monetary policy model for the short rate, we introduce a parsimonious and tractable model for the yield curve, which takes into account the possibility of regime shifts in the behavior of the Federal Reserve. In our empirical analysis, we show the merit of our approach along the following dimensions: (i) interpretable bond dynamics; (ii) accurate short end yield curve pricing; (iii) yield curve implications.
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    Scopus© Citations 5
  • Publication
    Aspirational Preferences and Their Representation by Risk Measures
    (INFORMS, 2012-11)
    Brown, David B
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    Sim, Melvyn
    We consider choice over a set of monetary acts and study a general class of preferences. These preferences favor diversification, except perhaps on a subset of sufficiently disliked acts, over which concentration is instead preferred. This structure encompasses a number of known models, such as expected utility theory, maxmin utility theory, and convex risk measures. We show that such preferences share a dual representation in terms of a family of measures of risk and a target function. Specifically, the choice function is equivalent to selection of a maximum index level such that the risk of beating the target function at that level is acceptable. This dual representation may help to uncover new models of choice. One that we explore in detail is the special case of a bounded target function. This case corresponds to a type of satisficing and has descriptive relevance. Moreover, the model results in optimization problems that may be efficiently solved in large-scale.
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    Scopus© Citations 33
  • Publication
    Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?
    (Wiley-Blackwell, 2012-03) ;
    Hens, Thorsten
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    Levy, Haim
    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.
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    Scopus© Citations 19
  • Publication
    Dynamic Portfolio Choice and Asset Pricing with Narrow Framing and Probability Weighting
    (Elsevier, 2012-07) ;
    Legg, Shane
    This paper shows that the framework proposed by Barberis and Huang (2009) to incorporate narrow framing and loss aversion in dynamic models of portfolio choice and asset pricing can be extended to also account for probability weighting and a value function which is convex on losses and concave on gains. We show that the addition of probability weighting and a convex-concave value function reinforces previous applications of narrow framing and cumulative prospect theory to explain the stock market non-participation puzzle and the equity premium puzzle. Moreover, we show that a convex-concave value function generates new wealth effects that are consistent with empirical observations on stock market participation.
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    Scopus© Citations 35
  • Publication
    A Behavioral Explanation of the Asset Allocation Puzzle
    (BusinessPerspective, 2011-12-01)
    This paper combines a behavioral reward-risk model based on prospect theory with multiple investment accounts to explain the asset allocation puzzle, that is, the observation that investors violate the two-fund separation property of optimal mean-variance allocations. In a empirical analysis with U.S. data, the authors show that investors with preference according to the behavioral reward-risk model and multiple investment accounts, invest a higher proportion into bonds and large cap stocks as their risk tolerance diminishes, consistently with the empirical findings.
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  • Publication
    Loss Aversion with Multiple Investment Goals
    (Springer Verlag, 2011-10-01)
    This paper presents a time-continuous portfolio selection model with loss averse investors, who possess multiple investment goals at different time horizons. The model assumes partial narrow framing. Investors follow a two-step approach. First, they optimally allocate wealth among investment goals. Second, they determine an optimal investment strategy for each investment goal separately. We show that when loss aversion is according to the experimental findings, investors mainly invest their wealth to reach long-term goals and adopt investment strategies with high leverage to reach short-term goals. The overall strategy also display high leverage. The same patterns is observed when loss aversion is extreme and goals are very ambitious. By contrast, when loss aversion is extreme but goals are not too ambitious, investors mainly invest to reach short-term goals and adopt safe investment strategies for this purpose.
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    Scopus© Citations 10
  • Publication
    A note on reward-risk portfolio selection and two-fund separation
    (Elsevier Science, 2011-06-01) ;
    Hens, Thorsten
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    Mayer, Janos
    This paper presents a general reward-risk portfolio selection model and derives sufficient conditions for two-fund separation. In particular we show that many reward-risk models presented in the literature satisfy these conditions.
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    Scopus© Citations 9
  • Publication
    Loss Aversion with a State-dependent Reference Point
    (Informs, 2011-04-29) ;
    Post, Thierry
    This study investigates reference-dependent choice with a stochastic, state-dependent reference point. The optimal reference-dependent solution equals the optimal consumption solution (no loss aversion) if the reference point is selected fully endogenously. Given that loss aversion is widespread, we conclude that the reference point generally includes an important exogenously fixed component. We develop a choice model in which adjustment costs can cause stickiness relative to an initial, exogenous reference point. Using historical U.S. investment benchmark data, we show that this model is consistent with diversification across bonds and stocks for a wide range of evaluation horizons, despite the historically high-risk premium of stocks compared to bonds.
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    Scopus© Citations 35