Prospect Theory and the CAPM: A contradiction or coexistence?

Haim Levy · Enrico G. De Giorgi · Thorsten Hens

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Financial Markets and Investment Strategies Decision-Making and Behavioral Economics Economic theories and models

Abstract

Under the assumption of normally distributed returns, we analyzenwhether the Cumulative Prospect Theory of Tversky and Kahneman (1992)nis consistent with the Capital Asset Pricing Model. We find that in everynfinancial market equilibrium the Security Market Line Theorem holds.nHowever, under the specific functional form suggested by Tversky andnKahneman (1992) financial market equilibria do not exist. We suggest annalternative functional form that is consistent with both, the experimentalnresults of Tversky and Kahneman and also with the existence of equilibria.

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References

1988Prospect theory: An analysis of decision under risk 1964CAPITAL ASSET PRICES: A THEORY OF MARKET EQUILIBRIUM UNDER CONDITIONS OF RISK*2019Theory of games and economic behavior 1992Advances in prospect theory: Cumulative representation of uncertainty 1961Risk, Ambiguity, and the Savage Axioms 1975THE VALUATION OF RISK ASSETS AND THE SELECTION OF RISKY INVESTMENTS IN STOCK PORTFOLIOS AND CAPITAL BUDGETS**This paper is another in a series of interrelated theoretical and statistical studies of corporate financial and investment policies being made under grants from the Rockefeller Foundation, and more recently the Ford Foundation, to the Harvard Business School. The generous support for this work is most gratefully acknowledged. The author is also much indebted to his colleagues Professors Bishop, Christenson, Kahr, Raiffa, and (especially) Schlaifer, for extensive discussion and commentary on an earlier draft of this paper; but responsibility for any errors or imperfections remains strictly his own.[Professor Sharpe's paper, “Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk” (Journal of Finance, September 1964) appeared after this paper was in final form and on its way to the printers. My first section, which parallels the first half of his paper (with corresponding conclusions), sets the algebraic framework for sections II, III and VI, (which have no counterpart in his paper) and for section IV on the equilibrium prices of risk assets, concerning which our results differ significantly for reasons which will be explored elsewhere. Sharpe does not take up the capital budgeting problem developed in section V below.]1966Equilibrium in a Capital Asset Market 1953Le Comportement de l'Homme Rationnel devant le Risque: Critique des Postulats et Axiomes de l'Ecole Americaine

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