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


Levy, Haim; De Giorgi, Enrico; Hens, Thorsten (2012). Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence? European Financial Management, 18(2):163-182.

Abstract

Markowitz and Sharpe won the Nobel Prize in Economics for the development of Mean-Variance (M-V) analysis and the Capital Asset Pricing Model (CAPM). Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. In deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU) maximisation in the face of risk aversion. Kahneman and Tversky suggest Prospect Theory (PT) as an alternative paradigm to EU theory. They show that investors distort probabilities, make decisions based on change of wealth, exhibit loss aversion and maximise the expectation of an S-shaped value function, which contains a risk-seeking segment. Can these two apparently contradictory paradigms coexist? We show in this paper that although CPT (and PT) is in conflict to EUT, and violates some of the CAPM's underlying assumptions, the Security Market Line Theorem (SMLT) of the CAPM is intact in the CPT framework. Therefore, the CAPM is intact also in CPT framework.

Abstract

Markowitz and Sharpe won the Nobel Prize in Economics for the development of Mean-Variance (M-V) analysis and the Capital Asset Pricing Model (CAPM). Kahneman won the Nobel Prize in Economics for the development of Prospect Theory. In deriving the CAPM, Sharpe, Lintner and Mossin assume expected utility (EU) maximisation in the face of risk aversion. Kahneman and Tversky suggest Prospect Theory (PT) as an alternative paradigm to EU theory. They show that investors distort probabilities, make decisions based on change of wealth, exhibit loss aversion and maximise the expectation of an S-shaped value function, which contains a risk-seeking segment. Can these two apparently contradictory paradigms coexist? We show in this paper that although CPT (and PT) is in conflict to EUT, and violates some of the CAPM's underlying assumptions, the Security Market Line Theorem (SMLT) of the CAPM is intact in the CPT framework. Therefore, the CAPM is intact also in CPT framework.

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Additional indexing

Item Type:Journal Article, not refereed, original work
Communities & Collections:03 Faculty of Economics > Department of Banking and Finance
Dewey Decimal Classification:330 Economics
Language:English
Date:2012
Deposited On:27 Mar 2012 11:47
Last Modified:05 Apr 2016 14:55
Publisher:Wiley
ISSN:1354-7798
Publisher DOI:https://doi.org/10.1111/j.1468-036X.2011.00617.x

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