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A Potential Contradiction Between Economic Theory and Applied Finance

Shlomo Yitzhaki ()

Review of Economics & Finance, 2016, vol. 6, 13-27

Abstract: One of the basic premises that underlies economic theory in Finance is the assumption of declining marginal utility of income. This assumption imposes risk-aversion on the investors and is necessary requirement to an equilibrium capital markets. A popular method of analyzing empirical evidence among financial analysts is the Ordinary Least Squares Regression. This paper argues that in certain cases involving violation of the linearity assumption by the data, there may be a contradiction between the two approaches. In order to resolve the possibility of a contradiction one has to impose economic theory on the regression. The paper proposes the use of the Gini regression to bridge the gap between economic theory and regression.

Keywords: Stochastic dominance; OLS regression; Gini regression (search for similar items in EconPapers)
JEL-codes: C00 C50 C53 C58 (search for similar items in EconPapers)
Date: 2016
Note: The author is grateful to an anonymous referee and Haim Shalit for helpful comments.
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