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Second-order stochastic dominance, reward-risk portfolio selection, and the CAPM


De Giorgi, Enrico; Post, Thierry (2008). Second-order stochastic dominance, reward-risk portfolio selection, and the CAPM. Journal of Financial and Quantitative Analysis, 43(2):525 -546.

Abstract

Starting from the reward-risk model for portfolio selection introduced in De Giorgi (2004), we derive the reward-risk Capital Asset Pricing Model (CAPM) analogously to the classical mean-variance CAPM. The reward-risk portfolio selection arises from an axiomatic definition of reward and risk measures based on few basic principles, including consistency with second order stochastic dominance. With complete markets, we show that at any financial market equilibrium, investors’ optimal allocations are comonotonic and therefore the capital market equilibrium model can be reduced to a representative investor model. Moreover, the pricing kernel is an explicitly given, monotone function of the market portfolio return, corresponding to the increments
of the distortion function characterizing the epresentative investor’s risk perceptions. Finally, an empirical application shows that the reward-risk CAPM better captures
the cross-section of US stock returns than the ean-variance CAPM does.

Abstract

Starting from the reward-risk model for portfolio selection introduced in De Giorgi (2004), we derive the reward-risk Capital Asset Pricing Model (CAPM) analogously to the classical mean-variance CAPM. The reward-risk portfolio selection arises from an axiomatic definition of reward and risk measures based on few basic principles, including consistency with second order stochastic dominance. With complete markets, we show that at any financial market equilibrium, investors’ optimal allocations are comonotonic and therefore the capital market equilibrium model can be reduced to a representative investor model. Moreover, the pricing kernel is an explicitly given, monotone function of the market portfolio return, corresponding to the increments
of the distortion function characterizing the epresentative investor’s risk perceptions. Finally, an empirical application shows that the reward-risk CAPM better captures
the cross-section of US stock returns than the ean-variance CAPM does.

Citations

4 citations in Web of Science®
11 citations in Scopus®
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Additional indexing

Item Type:Journal Article, refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:June 2008
Deposited On:15 Jan 2009 12:12
Last Modified:05 Apr 2016 12:49
Publisher:Cambridge University Press
ISSN:0022-1090
Additional Information:This research has been carried out within the NCCR FINRISK project on “Evolution and Foundations of Financial Markets”. Copyright: Cambridge University Press.
Publisher DOI:https://doi.org/10.1017/S0022109000003616
Official URL:http://search.ebscohost.com/login.aspx?direct=true&db=buh&AN=32504223&loginpage=Login.asp&site=ehost-live

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