INSIGHTS: Risk and Return in Behavioral SDF-Based Asset Pricing Models

Hersh Shefrin

Volume 6, Number 4, Fourth Quarter 2008

Behavioral finance has profound implications for the pricing of all assets, from standard fixed income securities and equity to complex derivatives. This paper describes a general, unified framework for analyzing the impact of sentiment on asset prices. The approach brings together the psychological assumptions favored by behavioral asset pricing theorists and the powerful pricing kernel-based methodology favored by neoclassical asset pricing theorists. Methodologically, change of measure techniques are used to provide a formal definition of sentiment and to capture the impact of behavioral beliefs and preferences on asset prices. Introducing behavioral assumptions into a pricing kernel framework provides insights into the impact of psychological features on the relationship between risk and return, mean-variance portfolios, the role of coskewness, and the pricing of derivatives. A behavioral theory for the pricing of derivatives is particularly germane to understanding the major turmoil in global financial markets which took place in 2008. That turmoil, which reflected highly volatile swings of sentiment in the markets for both equity and debt, stemmed from significant sentiment in the market for mortgages and derivatives based on mortgages.