TY - JOUR
T1 - Second-order stochastic dominance, reward-risk portfolio selection, and the CAPM
AU - De Giorgi, Enrico
AU - Post, Thierry
N1 - Funding Information:
∗De Giorgi, enrico.degiorgi@lu.unisi.ch, University of Lugano, via Buffi 13, CH-6900 Lugano, Switzerland; Post, gtpost@few.eur.nl, Erasmus School of Economics, Erasmus University Rotterdam, Room H14-11, P.O. Box 1738, 3000 DR, Rotterdam, The Netherlands. Financial support from the Foundation for Research and Development at the University of Lugano, the National Center of Competence in Research “Financial Valuation and Risk Management” (NCCR-FINRISK), the Tinbergen Institute, the Erasmus Research Institute of Management, and the Erasmus Center of Financial Research is gratefully acknowledged. We received useful comments from Thorsten Hens, Olivier Scail-let, Fabio Trojani, Terry Rockafellar, Pim van Vliet, Philippe Versijp, and Mark Schroder and Lance Young (the referees). An earlier version of the paper was presented at the NCCR-FINRISK Research Day in Berne, at the International Conference on Risk Management and Quantitative Approaches in Finance in Gainesville, Florida, and at the 14th European Workshop on General Equilibrium Theory in Zurich. We thank the participants for their helpful comments and suggestions. Pim van Vliet is credited for making the data available.
PY - 2008/6
Y1 - 2008/6
N2 - 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.
AB - 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.
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U2 - 10.1017/s0022109000003616
DO - 10.1017/s0022109000003616
M3 - Article
AN - SCOPUS:46849110164
VL - 43
SP - 525
EP - 546
JO - Journal of Financial and Quantitative Analysis
JF - Journal of Financial and Quantitative Analysis
SN - 0022-1090
IS - 2
ER -