Predictive Power of Prospect Theory: Empirical Tests in Bond and Stock Market

Abstract

Since the 1980s, prospect theory has been considered as the most successful descriptive theory for decision making. In this thesis, we examine the predictive power of prospect theory in two asset markets, the US corporate bond market and Chinese stock market. The empirical evidences from the two markets show that prospect theory has significant predictive power for subsequent returns.
The first study is based on the US bond market. Empirical results show that prospect theory has stronger predictive power for junk bond returns. Unlike the finding in stock market, the loss aversion component plays the most important role in predicting corporate bond returns. The probability weighting component also plays a predictive role for junk bonds, but not for investment-grade bonds.
The second study is based on the Chinese stock market. Previous studies suggest that individual investors rely more on their intuition when making investment decisions. Using equity division reform as exogenous shock and Chinese stock market data, we directly test the predictive power of prospect theory. Results show that prospect theory has stronger predictive power for Non-SOEs that are dominated by individual investors. Different from previous findings, all the three components of prospect theory (LA, PW, and CC) significantly contribute to PTV s predictive power. After the equity division reform, the predictive power of prospect theory and its three components is much stronger, especially for SOEs.

Date of Award	18 Aug 2017
Original language	English
Awarding Institution	City University of Hong Kong
Supervisor	Junbo WANG (Supervisor)