Compound Utility and Asset Pricing

摘要

Compound utility theory (CUT) offers an alternative to prospect theory, modelling nonlinear preferences without probability transformation. Applying CUT to port- folio choice and asset pricing, this paper investigate implications of nonlinear preferences for the structure of stochastic discount factor under various assumptions. Testable hypotheses are derived that seem to enrich current understanding in asset pricing relations signi.cantly. Unlike psychologically motivated approaches that often seems to suggest investor irrational- ity, we show that most of the empirical .anomalies. can be rationally accommodated by the assumption that investors.have quasiconcave preferences in probabilities. In addition,this study leads to a convenient framework for empirical investigations of the structure and behavior of stochastic discount factors under upper- and lower-market conditions separately.