The Prospect Capital Asset Pricing Model : Theory and Empirics

We propose a Capital Asset Pricing Model where investors exhibit prospect preferences. In equilibrium, we find that agents seek an optimal trade-off between expected returns, variance, and skewness. All assets in the economy are then priced by a three-factor model, which augments the security market line with two factors that respectively capture positive and negative coskewness with the market portfolio. Using U.S. stock market data, we find evidence consistent with these predictions. In additional tests, we find that the results are stronger among stocks traded by less sophisticated investors. Overall, prospect preferences have a substantial effect on stock prices