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Stocks as Lotteries: The Implications of Probability Weighting for Security Prices

Stocks as Lotteries: The Implications of Probability Weighting for Security Prices Abstract We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with a particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with nonunique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be “overpriced” and can earn a negative average excess return. We argue that our analysis offers a unifying way of thinking about a number of seemingly unrelated financial phenomena. (JEL D81 , G11 , G12 ) http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png American Economic Review American Economic Association

Stocks as Lotteries: The Implications of Probability Weighting for Security Prices

Barberis, Nicholas; Huang, Ming
American Economic Review , Volume 98 (5) – Dec 1, 2008
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Publisher
American Economic Association
Copyright
Copyright © 2008 by the American Economic Association
Subject
Articles
ISSN
0002-8282
DOI
10.1257/aer.98.5.2066
Publisher site
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Abstract

Abstract We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with a particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with nonunique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be “overpriced” and can earn a negative average excess return. We argue that our analysis offers a unifying way of thinking about a number of seemingly unrelated financial phenomena. (JEL D81 , G11 , G12 )

Journal

American Economic Review – American Economic Association

Published: Dec 1, 2008

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