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Conditional Risk Premiums and the Value Function of Prospect Theory

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  • Martin Walther
  • Markus Münster

Abstract

This paper examines whether stock returns are consistent with the value function of prospect theory. We find that beta given a gain yields positive conditional premiums on returns while beta given a loss yields negative conditional premiums. This reflects the fact that the value function is concave for gains and convex for losses, implying risk-averse behavior for gains and risk-seeking behavior for losses respectively. Furthermore, the absolute value of the premiums is greater for losses, which is in line with the value function being steeper in this state. These new findings provide indication that investors behave according to prospect theory.

Suggested Citation

  • Martin Walther & Markus Münster, 2021. "Conditional Risk Premiums and the Value Function of Prospect Theory," Journal of Behavioral Finance, Taylor & Francis Journals, vol. 22(1), pages 74-83, January.
    • Handle: RePEc:taf:hbhfxx:v:22:y:2021:i:1:p:74-83
    DOI: 10.1080/15427560.2020.1735390
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    Cited by:

    1. Felix Reichenbach & Martin Walther, 2023. "Financial recommendations on Reddit, stock returns and cumulative prospect theory," Digital Finance, Springer, vol. 5(2), pages 421-448, June.
    2. Chi-Lu Peng & Wen-Kuei Chen & An-Pin Wei, 2021. "Teaching CAPM for a Pre-Finance Graduate Program at the STEM Undergraduate Level: Linear Algebra Perspective," Mathematics, MDPI, vol. 9(14), pages 1-22, July.
    3. Bennett, Donyetta & Mekelburg, Erik & Williams, T.H., 2023. "BeFi meets DeFi: A behavioral finance approach to decentralized finance asset pricing," Research in International Business and Finance, Elsevier, vol. 65(C).
    4. Jiang, Ping & Wang, Xinyi & Yuan, Bozong & Zhao, Lu, 2024. "Do investors prefer multiple small bad news events or a single big one? Evidence from the Chinese stock market," Finance Research Letters, Elsevier, vol. 62(PA).

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