【Topic】Compound Utility Theory and Asset Pricing

【Abstract】Compound utility theory (Zou, 2006 AEF) proposes a two-stage process for decision making under risk. In the first stage, the decision maker evaluates his expected utility EU for upside reward and expected disutility ED to downside risk of all feasible actions. He then chooses in the second stage the action that offers the best utility-disutility tradeoff according to his compound utility function V(EU, ED). In this paper, we apply compound utility theory to portfolio choice and asset pricing and show that, under two mild axioms, EU and ED reduce to expected gain and expected loss, where the reference point defining gain and loss is the risk-free return. In such a setting, the shape of V captures investors’ risk attitudes, and the capital market is gain-loss efficient. The equilibrium condition implies then a simple, dichotomous stochastic discount factor for pricing all assets and contingent claims on these assets. If at-the-money options on the market portfolio are tradable, then gain-loss efficiency also implies mean-variance efficiency and the dichotomous asset pricing model (Zou, 2005 AEF) holds. We provide a brief discussion of the empirical issues regarding the validity of the CAPM and various multifactor models.

【Speaker】Liang Zou Associate Professor of Finance at the University of Amsterdam

【Time】10:00 am, October 26 (Friday)

【Location】 Hanqing Teacher Exchange Room 0515b, Mingde Main Building

Dr. Liang Zou from the University of Amsterdam holds a BSc degree in mathematics (1982, Peking Univ.), MBA (1986, KUL Belgium), and Ph.D. in economics (1990, CORE Belgium). Being an active researcher, he has published many articles in top-tier international journals, some of which being influential in providing insights into ownership structure and efficiency, reforming state-owned enterprises and economic transitions in China. His research has been ranked the 5th among the top 40 business economists in the Netherlands and Belgium (Flemish region), and the 3rd among the top 15 financial economists in the Netherlands. He has served as director of the Master of Science program for the Amsterdam Business School and helped the school develop into today’s modern faculty of international reputation. Liang Zou currently lives in the Netherlands and can be reached by email: L.Zou@uva.nl.