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

Haim Levy, Enrico De Giorgi () and Thorsten Hens

No 161, IEW - Working Papers from Institute for Empirical Research in Economics - University of Zurich

Abstract: Markowitz and Sharpe won the Nobel Prize in Economics more than a decade ago for the development of Mean-Variance analysis and the Capital Asset Pricing Model (CAPM). In the year 2002, Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. Can these two apparently contradictory paradigms coexist? In deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU) maximization following the approach proposed by Markowitz, normal distributions and risk aversion. Kahneman & Tversky suggest Prospect Theory (PT) and Cumulative Prospect Theory (CPT) as an alternative paradigm to EU theory. They show that investors distort probabilities, make decisions based on change of wealth, exhibit loss aversion and maximize the expectation of an S-shaped value function which contains a risk-seeking segment. Employing change of wealth rather than total wealth contradicts EU theory. The subjective distortion of probabilities violates the CAPM assumptions of normality and homogeneous expectations, and the S-shaped value function violates the risk aversion assumption. We prove 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.

Keywords: Capital Asset Pricing Model; Prospect Theory (search for similar items in EconPapers)
JEL-codes: C62 D51 D52 G11 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-hpe
References: Add references at CitEc
Citations: View citations in EconPapers (14)

Downloads: (external link)
https://www.zora.uzh.ch/id/eprint/52057/1/iewwp161.pdf (application/pdf)

Related works:
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:zur:iewwpx:161

Access Statistics for this paper

More papers in IEW - Working Papers from Institute for Empirical Research in Economics - University of Zurich
Bibliographic data for series maintained by Severin Oswald ().