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

Authors


  • Research of the author Haim Levy is supported by the Krueger Institute of Finance at the Hebrew University. Research of the author Enrico G. De Giorgi is supported by the Swiss National Science Foundation (grant 105214-130078) and by the Swiss national centre of competence in research ‘Financial Valuation and Risk Management’ (NCCR-FINRISK). Research of the author Thorstern Hens is supported by the Swiss national centre of competence in research ‘Financial Valuation and Risk Management’ (NCCR-FINRISK).

Abstract

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.

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