Loss aversion and the price of risk

M. Levy*

*Corresponding author for this work

Research output: Contribution to journalArticlepeer-review

10 Scopus citations

Abstract

This paper derives a simple theoretical relationship between the degree of loss aversion, the concavity/convexity of the value function, and the equilibrium market price of risk. We show that while the degree of loss aversion is key in determining the market price of risk, the convexity/concavity of the value function is much less important in this respect. The theoretical relationship obtained is tested empirically by using international data from 16 different countries during over 100 years, as documented by Dimson et al. [Triumph of the Optimists: 101 Years of Global Investment Returns, 2002 (Princeton University Press)]. The empirical data yield an estimate of λ 2:3 for the loss aversion index. This value is in striking agreement with estimates obtained in the very different methodology of laboratory experiments of individual decision-making.

Original languageAmerican English
Pages (from-to)1009-1022
Number of pages14
JournalQuantitative Finance
Volume10
Issue number9
DOIs
StatePublished - 2010

Bibliographical note

Funding Information:
I am grateful to the two anonymous referees for their many helpful comments and suggestions. This work has benefited from lively discussions and comments by seminar participants at UCLA and the Hebrew University. Excellent research assistance was provided by Sher Niv. The financial support of the Zagagi Fund is gratefully acknowledged.

Keywords

  • Capital asset pricing
  • Economics of risk
  • Finance
  • Loss aversion

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