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American Economic Review: Vol. 98 No. 5 (December 2008)

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Stocks as Lotteries: The Implications of Probability Weighting for Security Prices

Article Citation

Barberis, Nicholas, and Ming Huang. 2008. "Stocks as Lotteries: The Implications of Probability Weighting for Security Prices." American Economic Review, 98(5): 2066-2100.

DOI: 10.1257/aer.98.5.2066

Abstract

We study the asset pricing implications of Tversky and Kahneman's (1992) cumulative prospect theory, with a particular focus on its probability weighting component. Our main result, derived from a novel equilibrium with nonunique global optima, is that, in contrast to the prediction of a standard expected utility model, a security's own skewness can be priced: a positively skewed security can be "overpriced" and can earn a negative average excess return. We argue that our analysis offers a unifying way of thinking about a number of seemingly unrelated financial phenomena. (JEL D81, G11, G12)

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Authors

Barberis, Nicholas (Yale U)
Huang, Ming (Cornell U and Cheung Kong Graduate School of Business)

JEL Classifications

D81: Criteria for Decision-Making under Risk and Uncertainty
G11: Portfolio Choice; Investment Decisions
G12: Asset Pricing; Trading volume; Bond Interest Rates


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