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Asset Prices Under Prospect Theory and Habit Formation

Author

Listed:
  • Mao-Wei Hung

    (College of Management, National Taiwan University, No. 50, Lane 144, Keelung Road, Section 4, Taipei, Taiwan, R.O.C.)

  • Jr-Yan Wang

    (Department of Finance, National Chung Hsing University, No. 250, Kuo Kuang Rd., Taichung, Taiwan, R.O.C.)

Abstract

In this paper, we develop a consumption-based asset pricing model motivated by prospect theory, where habit formation determines the endogenous reference point. This exploits the similarity between habit formation and prospect theory. Both emphasize that the investor does not care about the absolute amount of gain or loss, but rather compares the gain or the loss experienced to a benchmark. The results show that when taking people's loss averse attitude over consumption into consideration, our model is capable of resolving the equity premium puzzle.

Suggested Citation

  • Mao-Wei Hung & Jr-Yan Wang, 2005. "Asset Prices Under Prospect Theory and Habit Formation," Review of Pacific Basin Financial Markets and Policies (RPBFMP), World Scientific Publishing Co. Pte. Ltd., vol. 8(01), pages 1-29.
    • Handle: RePEc:wsi:rpbfmp:v:08:y:2005:i:01:n:s0219091505000324
    DOI: 10.1142/S0219091505000324
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    References listed on IDEAS

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    1. Arjan B. Berkelaar & Roy Kouwenberg & Thierry Post, 2004. "Optimal Portfolio Choice under Loss Aversion," The Review of Economics and Statistics, MIT Press, vol. 86(4), pages 973-987, November.
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    Cited by:

    1. Michael Nwogugu, 2020. "Regret Theory And Asset Pricing Anomalies In Incomplete Markets With Dynamic Un-Aggregated Preferences," Papers 2005.01709, arXiv.org.
    2. Mark Freeman & Ben Groom, 2015. "Using equity premium survey data to estimate future wealth," Review of Quantitative Finance and Accounting, Springer, vol. 45(4), pages 665-693, November.
    3. Arie Harel & Jack Clark Francis & Giora Harpaz, 2018. "Alternative utility functions: review, analysis and comparison," Review of Quantitative Finance and Accounting, Springer, vol. 51(3), pages 785-811, October.

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    More about this item

    Keywords

    Prospect theory; habit formation; loss aversion; consumption-based asset pricing model;
    All these keywords.

    JEL classification:

    • G1 - Financial Economics - - General Financial Markets
    • G2 - Financial Economics - - Financial Institutions and Services
    • G3 - Financial Economics - - Corporate Finance and Governance

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