Effects of the fat-tail distribution on the relationship between prospect theory value and expected return

Cheoljun Eom and Jong Won Park

The North American Journal of Economics and Finance, 2020, vol. 51, issue C

Abstract: This study investigates the negative relationship between prospect theory value and expected return considering the fat-tail property of the return distribution. The results of both decile portfolio and cross-sectional regression show evidence supporting the hypothesis related to prospect theory value. However, these results are very sensitive to whether the model includes a short-term reversal factor. In the empirical design combining the hypothesis with the degree of fat-tail of the return distribution, stock groups with the fat-tail return distribution definitely show that prospect theory value has a significant information value for explaining expected return, regardless of whether the short-term reversal and other factors are included in the models. These results suggest that both the fat-tail property in the stock return distribution and the property of the skewed return distribution must be considered in examining the relationship between prospect theory value and expected return. Furthermore, our findings on the effects of the fat-tail property of the return distribution are verified through robustness testing while considering changes in empirical design and using out-of-sample stock markets of the U.S., Japan, and China, as well as the in-sample Korean stock market.

Keywords: Prospect theory value; Decision weight; Skewed distribution; Fat-tail distribution; Out-of-sample test (search for similar items in EconPapers)
JEL-codes: G11 G40 (search for similar items in EconPapers)
Date: 2020
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (4)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:ecofin:v:51:y:2020:i:c:s1062940819300075

DOI: 10.1016/j.najef.2019.101052

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