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Stocks as lotteries: The implications of probability weighting for security prices

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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.

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[Barberis, Nicholas] Yale Univ, Sch Management, 135 Prospect St,POB 208200, New Haven, CT 06520 USA

[Huang, Ming] Cornell Univ, Johnson Sch, Ithaca, NY 14853 USA ; Cheung Kong Grad Sch Business, Beijing, Peoples R China


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Source

American Economic Review

ISSN:0002-8282

Year:2008

Issue:5

Volume:98

Page:2066-2100

Powered by JCR@2008

ESI Discipline:ECONOMICS & BUSINESS;

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