Beta and Coskewness Pricing: Perspective from Probability Weighting

Yun Shi (), Xiangyu Cui () and Xun Yu Zhou ()
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Yun Shi: School of Statistics and Academy of Statistics and Interdisciplinary Sciences, East China Normal University, Shanghai 200062, China
Xiangyu Cui: School of Statistics and Management, Shanghai Institute of International Finance and Economics, Shanghai University of Finance and Economics, Shanghai 200437, China
Xun Yu Zhou: Department of Industrial Engineering and Operations Research, and The Data Science Institute, Columbia University, New York, New York 10027

Operations Research, 2023, vol. 71, issue 2, 776-790

Abstract: The security market line is often flat or downward-sloping. We hypothesize that probability weighting plays a role and one ought to differentiate between periods in which agents overweight extreme events and those in which they underweight them. Overweighting inflates the probability of extremely bad events and demands greater compensation for beta risk, whereas underweighting does the opposite. Unconditional on probability weighting, these two effects offset each other, resulting in a flat or slightly negative return–beta relationship. Similarly, overweighting the tails enhances the negative relationship between return and coskewness, whereas underweighting reduces it. We derive a three-moment conditional capital asset pricing model for a market with rank-dependent utility agents to make these predictions, and we support our theory through an extensive empirical study.

Keywords: Financial Engineering; behavioral finance; probability weighting; rank-dependent utility; asset pricing; beta anomaly (search for similar items in EconPapers)
Date: 2023
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Persistent link: https://EconPapers.repec.org/RePEc:inm:oropre:v:71:y:2023:i:2:p:776-790

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