# Developing a Behavioural Asset Pricing Model

## People

Leaders

**De Giorgi E.**

(Responsible)

## Abstract

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.

## Additional information

**01.01.2006**

**01.01.2009**

**36 Months**

**Fondazione ricerca e sviluppo dell´USI**

**Ended**

**S180 Economics, econometrics, economic theory and systems, economic policy**

S181 Financial sciences

P160 Statistics, operation research, programming, actuarial mathematics

S181 Financial sciences

P160 Statistics, operation research, programming, actuarial mathematics

## Publications

- De Giorgi E., Hens T., Levy H. (2012) Two Paradigms and Nobel Prizes in Economics: A Contradiction or Coexistence?, European Financial Management
- De Giorgi E., Hens T., Mayer J. (2011) A Note on Reward-Risk Portfolio Selection and Two-Fund Separation, Finance Research Letters, 8(2):52-58
- De Giorgi E., Post T. (2011) Loss Aversion with a State-dependent Reference Point, Management Science, 57(6), pp. 1094-1110
- De Giorgi E., Hens T., Rieger M. O. (2010) Financial Market Equilibria with Cumulative Prospect Theory, Journal of Mathematical Economics, 46(5), pp. 633–651
- De Giorgi E., Hens T. (2009) Prospect Theory and Mean-Variance Analysis: Does it Make a Difference in Wealth Management?, Investment Management and Financial Innovations, 6(1), pp. 122-129.
- De Giorgi E. (2008) Evolutionary Portfolio Selection with Liquidity Shocks, Journal of Economic Dynamics and Control, 32(4), pp. 1088-1119
- De Giorgi E., Post T. (2008) Second Order Stochastic Dominance, Reward-Risk Portfolio Selection and the CAPM, Journal of Financial and Quantitative Analysis, 43(2):525-546
- De Giorgi E., Reimann S. (2008) The alpha-Beauty Contest: Choosing Numbers, Thinking Intervals, Games and Economic Behavior, 64(2), pp. 470-486.
- De Giorgi E., Audrino F. (2007) Beta Regimes for the Yield Curve, Journal of Financial Econometrics, 5(3), pp. 456-490
- De Giorgi E., Hens T., Mayer J. (2007) Computational Aspects of Prospect Theory with Asset Pricing Applications, Computational Economics, 29(3-4), pp. 267-281
- De Giorgi E. (2006) A Risk-Reward Perspective on Prospect Theory with Application to the Asset Allocation Puzzle. BSI Gamma Foundation, Conference on Behavioral Finance, Frankfurt
- De Giorgi E. (2006) Behavioral Foundation of Reward-Risk Portfolio Selection and the Asset Allocation Puzzle. European Finance Association 2006, Zurich
- De Giorgi E., Hens T. (2006) Making Prospect Theory Fit for Finance, Financial Markets and Portfolio Management, 20(3), pp. 339-360