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.
Journal of Consumer Research
A medium-for example, points or money-is a token people receive as the immediate reward of their effort. It has no value in and of itself, but it can be traded for a desired outcome. Experiments demonstrate that, when people are faced with options entailing different outcomes, the presence of a medium can alter what option they choose. This effect occurs because the medium presents an illusion of advantage to an otherwise not so advantageous option, an illusion of certainty to an otherwise uncertain option, or an illusion of linearity to an otherwise concave effort-outcome return relationship. This work has implications for how points influence consumer choice and how money influences human behavior.
Address correspondence to Christopher K. Hsee. Many individuals have provided helpful comments on this research. In particular, the authors thank Pankaj Aggarwal, Danny Kahneman, Yuval Rottenstreich, Suzanne Shu, Jack Soll, Dick Thaler, Stijn van Osselaer, George Wu, and the JCR editor, associate editor, and reviewers for their helpful comments on drafts of this article. Funding for this project is provided by the University of Chicago Graduate School of Business, the National Science Foundation, and China Europe International Business School.