Conditional Risk Premiums and the Value Function of Prospect Theory

Abstract

This paper examines whether stock returns are consistent with the value function of prospect theory. We find that beta given a gain yields positive conditional premiums on returns while beta given a loss yields negative conditional premiums. This reflects the fact that the value function is concave for gains and convex for losses, implying risk-averse behavior for gains and risk-seeking behavior for losses respectively. Furthermore, the absolute value of the premiums is greater for losses, which is in line with the value function being steeper in this state. These new findings provide indication that investors behave according to prospect theory.