A Note on a Framework to Assess the Required Equity Risk Premium Using Cumulative Prospect Theory

Chris Holdsworth, Eben Maré

Department of Mathematics and Applied Mathematics, University of Pretoria, Pretoria, South Africa.
Investec Securities, Investec, Cape Town, South Africa.

DOI: 10.4236/tel.[phone]                

Abstract

We provide a framework to ascertain the required equity risk premium (ERP) within the setting of Cumulative Prospect Theory (CPT) over arbitrary investment time periods. Once accounting for behavioral biases in estimating distributions (generated by using a simulation of asset returns based on a sampling procedure) and using a CPT utility function, it becomes apparent that the key determinant of the required ERP is an investor’s time horizon.

Keywords

Cumulative Prospect Theory; Equity Risk Premium; Investment Time Horizon; Multi-Asset Allocation

Conflicts of Interest

The authors declare no conflicts of interest.

References

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