Equity Premium Puzzle, Prospect Theory and Subprime Crisis
Year: 2012
Type: preprint
Abstract: (ProQuest: ... denotes formulae omitted.)IntroductionExpected utility theory, a predominant framework for modeling decision making under risk, typically assumes that agents make rational choices, evaluate wealth according to final asset positions and evaluate probability objectively. However, substantial experimental evidences have indicated that agents fail to follow the assumptions of expected utility theory. In fact, they violate risk preference assumptions when facing uncertainties. As a consequence, alternative models have been developed by behavioral finance researchers.The field of behavioral finance is very relevant for better studying and understanding human judgment. Behavioral models like Prospect Theory (PT), developed by Kahneman and Tversky (1979), infuse a more realistic assumption of investor behavior. In 1992, Tversky and Kahneman extended the PT framework and developed a new version of PT called Cumulative Prospect Theory (CPT).PT arguments have been increasingly used to explain a range of anomalies observed in financial markets like the disposition effect, momentum (Menkhoffand Schmeling, 2006), excess of volatility, stock return predictability, and the trading behavior. More specifically, CPT has an important impact on empirical researches of the equity premium puzzle.The equity premium which is defined as the return on the stock less the return on the risk-free asset is an observable phenomenon in the US. Mehra and Prescott (1985) show a high equity premium in US. The degree of risk aversion necessary to explain this premium is very high compared to the experimental evidence. Thus, the equity premium puzzle has simulated an extensive research effort in behavioral finance (Han and Hsu, 2004).Benartzi and Thaler (1995) propose an explanation of this puzzle based on two behavioral concepts: loss aversion and mental accounting. They dub this combination as Myopic Loss Aversion (MLA). Loss aversion specifies that individuals are more sensitive to losses than to gains. Mental accounting (Kahneman and Tversky, 1984; and Thaler, 1985) specifies that individuals employ implicit methods to code and evaluate financial outcomes.Behavioral biases which affect the psychology of the investor play an important role in the robustness of the equity premium phenomenon and in the occurrence of subprime crisis. In this perspective, CPT helps to provide an explanation as to how the subprime crisis has resulted. Indeed, mortgage lenders lend money to individuals with poor credit ratings (the higher risk individuals) who can no longer afford the payment of their credit. The combination of the US property prices falling and the default of credit payments led to the collapse of many financial institutions. The massive losses experienced by these institutions incite loss-averse investor to take the risk (selling the risky stocks) to avoid losses as a result of decreasing stock prices. The phenomenon of continuous selling of stocks implies the decreasing prices of risky stocks prices and thus the occurrence of subprime crisis (Agarwal, 2008).A voluminous literature is available on equity premium puzzle, but there are very few published papers which studied the equity premium puzzle before and during the subprime crisis in the developed and emerging markets. Thus, this paper makes several important contributions to the literature on equity premium. First, we empirically examine the variability of the equity premium before and during the subprime crisis across developed and emerging markets. So, we study the difference of equity premium behavior between markets and sample periods. The financial markets of 20 countries-US, Canada, Brazil, Mexico, Argentina, France, Germany, Austria, UK, the Netherlands, Switzerland, Australia, Hong Kong, Japan, Korea, Malaysia, Singapore, India, Kuwait and Tunisia-for the period 1999-2010 are considered for the study. Second, using a simulation approach, we investigate the role of loss aversion and mental accounting in explaining large equity premium observed in financial markets. …
Source: SSRN Electronic Journal
Institution: University of Sfax
Language: English
Subfield: Finance
Domain: Social Sciences
Open Access status: green
OpenAlex ID: W3122935500