Prospect Theory and Asset Pricing in an RBC Framework

We construct a fully-fledged production economy model with Kahneman and Tversky’s Prospect Theory features. The agents’ objective function is a weighted sum of the usual utility over consumption and leisure and the utility over the relative changes of the agents’ wealth. It is also assumed that the agents are more sensitive to wealth losses than to gains. Apart from the changes in the utility, our RBC model is standard. We study prices of different assets in our economy. It is demonstrated that under plausible parametrizations of the objective function our model explains all first and second moments of the returns on risky assets, short bonds and long bonds. In particular, we are able to match the empirical Sharpe Ratio, the equity premium and the volatilities of the risky asset and the riskless bond.