Higher-Moment Capital Asset Pricing and Its Behavioral Implications

Abstract

Mental accounting, as depicted in the preceding chapter, organizes potentially bewildering financial information in ways that address humans’ physiological, social, and emotional needs. These processes operate at the level of the self and at the level of civilized society addressing risk management and resource allocation questions of global proportions. Having introduced these simplifying frames of thought in purely qualitative terms, this book will now present some of the quantitative tools that undergird not only mathematical finance in the traditional sense, but also behavioral finance as an extension beyond strictly rational considerations of risk and return. After describing the capital asset pricing model (CAPM) in its conventional form, this chapter will present a four-moment CAPM as a Taylor series expansion of mean returns. Treating returns as the sum of their mean, variance, skewness, and kurtosis enables us to ascribe behavioral significance to the odd and even moments of the distribution of returns.¹