UZH-Logo

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


Levy, Haim; De Giorgi, Enrico; Hens, Thorsten (2003). Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence? Working paper series / Institute for Empirical Research in Economics No. 161, University of Zurich.

Abstract

Markowitz and Sharpe won the Nobel Prize in Economics more than a decade ago for thendevelopment of Mean-Variance analysis and the Capital Asset Pricing Model (CAPM). In the yearn2002, Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. Cannthese two apparently contradictory paradigms coexist?nIn deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU)nmaximization following the approach proposed by Markowitz, normal distributions and risknaversion. Kahneman & Tversky suggest Prospect Theory (PT) and Cumulative Prospect Theoryn(CPT) as an alternative paradigm to EU theory. They show that investors distort probabilities,nmake decisions based on change of wealth, exhibit loss aversion and maximize the expectation ofnan S-shaped value function which contains a risk-seeking segment. Employing change of wealthnrather than total wealth contradicts EU theory. The subjective distortion of probabilities violatesnthe CAPM assumptions of normality and homogeneous expectations, and the S-shaped valuenfunction violates the risk aversion assumption. We prove in this paper that although CPT (and PT)nis in conflict to EUT, and violates some of the CAPM's underlying assumptions, the securitynmarket line theorem (SMLT) of the CAPM is intact in the CPT framework.

Markowitz and Sharpe won the Nobel Prize in Economics more than a decade ago for thendevelopment of Mean-Variance analysis and the Capital Asset Pricing Model (CAPM). In the yearn2002, Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. Cannthese two apparently contradictory paradigms coexist?nIn deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU)nmaximization following the approach proposed by Markowitz, normal distributions and risknaversion. Kahneman & Tversky suggest Prospect Theory (PT) and Cumulative Prospect Theoryn(CPT) as an alternative paradigm to EU theory. They show that investors distort probabilities,nmake decisions based on change of wealth, exhibit loss aversion and maximize the expectation ofnan S-shaped value function which contains a risk-seeking segment. Employing change of wealthnrather than total wealth contradicts EU theory. The subjective distortion of probabilities violatesnthe CAPM assumptions of normality and homogeneous expectations, and the S-shaped valuenfunction violates the risk aversion assumption. We prove in this paper that although CPT (and PT)nis in conflict to EUT, and violates some of the CAPM's underlying assumptions, the securitynmarket line theorem (SMLT) of the CAPM is intact in the CPT framework.

Downloads

447 downloads since deposited on 29 Nov 2011
103 downloads since 12 months
Detailed statistics

Additional indexing

Item Type:Working Paper
Communities & Collections:03 Faculty of Economics > Department of Economics
Working Paper Series > Institute for Empirical Research in Economics (former)
Dewey Decimal Classification:330 Economics
Language:English
Date:June 2003
Deposited On:29 Nov 2011 22:32
Last Modified:05 Apr 2016 15:10
Series Name:Working paper series / Institute for Empirical Research in Economics
ISSN:1424-0459
Official URL:http://www.econ.uzh.ch/wp.html
Permanent URL: http://doi.org/10.5167/uzh-52057

Download

[img]
Preview
Filetype: PDF
Size: 708kB

TrendTerms

TrendTerms displays relevant terms of the abstract of this publication and related documents on a map. The terms and their relations were extracted from ZORA using word statistics. Their timelines are taken from ZORA as well. The bubble size of a term is proportional to the number of documents where the term occurs. Red, orange, yellow and green colors are used for terms that occur in the current document; red indicates high interlinkedness of a term with other terms, orange, yellow and green decreasing interlinkedness. Blue is used for terms that have a relation with the terms in this document, but occur in other documents.
You can navigate and zoom the map. Mouse-hovering a term displays its timeline, clicking it yields the associated documents.

Author Collaborations