Second-order stochastic dominance, reward-risk portfolio selection, and the CAPM

Enrico De Giorgi, Thierry Post

Research output: Contribution to journalArticle

15 Citations (Scopus)

Abstract

Starting from the reward-risk model for portfolio selection introduced in De Giorgi (2005), we derive the reward-risk Capital Asset Pricing Model (CAPM) analogously to the classical mean-variance CAPM. In contrast to the mean-variance model, reward-risk portfolio selection arises from an axiomatic definition of reward and risk measures based on a few basic principles, including consistency with second-order stochastic dominance. With complete markets, we show that at any financial market equilibrium, reward-risk investors' optimal allocations are comonotonic and, therefore, our model reduces to a representative investor model. Moreover, the pricing kernel is an explicitly given, non-increasing function of the market portfolio return, reflecting the representative investor's risk attitude. Finally, an empirical application shows that the reward-risk CAPM captures the cross section of U.S. stock returns better than the mean-variance CAPM does.

Original languageEnglish
Pages (from-to)525-546
Number of pages22
JournalJournal of Financial and Quantitative Analysis
Volume43
Issue number2
Publication statusPublished - Jun 2008
Externally publishedYes

Fingerprint

Reward
Capital asset pricing model
Second-order stochastic dominance
Portfolio selection
Investors
Risk capital
Mean-variance
Mean-variance model
Stock returns
Market portfolio
Market equilibrium
Risk measures
Cross section
Financial markets
Risk model
Optimal allocation
Pricing kernel
Axiomatics
Risk attitude
Complete markets

ASJC Scopus subject areas

  • Finance
  • Accounting
  • Economics and Econometrics

Cite this

Second-order stochastic dominance, reward-risk portfolio selection, and the CAPM. / De Giorgi, Enrico; Post, Thierry.

In: Journal of Financial and Quantitative Analysis, Vol. 43, No. 2, 06.2008, p. 525-546.

Research output: Contribution to journalArticle

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