Developing a Behavioural Asset Pricing Model
De Giorgi E.
The project´s aim is the development of a behavioral portfolio theory and behavioural asset pricing models. In particular, we plan to consider the following issues.
1. Behavioral portfolio theory. The prospect theory of Kahneman and Tversky (1979) is based on the behavior of decision makers when faced to simple two-outcomes or threeoutcomes lotteries. While this simplified setup permits to identify the main features of investors¿ attitude when facing risky opportunities, one has to take into account that financial markets provide very complex lotteries, with a large number of possible outcomes and economic constraints. Consequently, in order to develop a portfolio theory that incorporates the main findings of prospect theory, one has first to understand how the prospect theory can be applied to the asset allocation problem and whether the solutions of the portfolio decision problem are robust with respect to the parameter specification.
2. Equilibrium consequences. The mean-variance CAPM results from the study of equilibrium outcomes of financial markets. Financial markets equilibria are given when all investors optimally allocate their resources and markets clear. First, one has to address the issue about the consistency of this definition of equilibrium with prospect theory preferences: Existence of equilibria and the conditions that ensure existence, multiple equilibria, etc. Then, one has to study the equilibrium outcomes of financial markets when investors are characterized by prospect theory preferences. Finally, a behavioral CAPM should be derived, hence founding a new asset pricing relationship on a strong decision theoretic framework. The goal will be to obtain an asset pricing formula ranking assets according to a new behavioral beta, that is expected to incorporate some measure of downside risk.
3. Empirical tests. The behavioral portfolio models and asset pricing models that follow from the previous points should be tested on market data. In particular one want to explain well-documented asset allocation puzzles (for example, the equity premium puzzle or the historically favorable risk-return trade-off of stocks relative to bonds, the size premium puzzle or the historically favorable risk-return trade-off of small cap stocks relative to large cap stocks, and the value premium puzzle or the favorable returns of value stocks relative to growth stocks) using a model of portfolio decision that is founded in the prospect theory.