The Prospect Capital Asset Pricing Model: Theory and Empirics

EWe propose a capital asset pricing model in which investors exhibit prospect preferences. In equilibrium, we predict that agents seek an optimal trade-off between expected returns, variance, and skewness. Specifically, assets with positive coskewness increase risk in the region of gains (investors are risk-averse), whereas assets with negative coskewness reduce risk in the region of losses (investors are risk-loving). Using U.S. stock market data, we find evidence consistent with the above theoretical predictions. A 1% rise in positive coskewness factor loading leads to 0.42% more stock returns. The negative coskewness coefficients are also positive and significant. The empirics indicate a 0.53% return increase for each 1% increase in the negative coskewness factor loading. In additional tests, we find that the results become stronger among stocks traded by less sophisticated investors. Overall, the implication is that there is a pervasive impact of prospect utility in financial markets.