“Prospect Theory, the Disposition Effect and Asset Prices” by Liyan YANG
Authors:
Liyan YANG
Cornell UniversityYan Li
Cornell University
This paper proposes a full equilibrium model for studying the implications of the S-shaped value function of prospect theory for individual trading, security prices and trading volume. We show that (i) the concavity/convexity of the value function can drive the disposition effect; (ii) the disposition effect can lead to momentum in the cross-section of stock returns; (iii) the disposition effect can explain why there is more trading in rising markets than in falling markets; and (iv) the concavity/convexity of the value function alone, in the absence of loss aversion, raises equity premiums. In particular, prospect theory preference with Tversky and Kahneman (1992JRU) parameter values generates annual price momentum of roughly 1% in a calibrated economy.
