Regret Theory And Asset Pricing Anomalies In Incomplete Markets With Dynamic Un-Aggregated Preferences

Abstract

Although the CML (Capital Market Line), the Intertemporal-CAPM, the CAPM/SML (Security Market Line) and the Intertemporal Arbitrage Pricing Theory (IAPT) are widely used in portfolio management, valuation and capital markets financing; these theories are inaccurate and can adversely affect risk management and portfolio management processes. This article introduces several empirically testable financial theories that provide insights, and can be calibrated to real data and used to solve problems, and contributes to the literature by: i) explaining the conditions under which ICAPM/CAPM, IAPT and CML may be accurate, and why such conditions are not feasible; and explaining why the existence of incomplete markets and dynamic un-aggregated markets render CML, IAPT and ICAPM inaccurate; ii) explaining why the Consumption-Savings-InvestmentProduction framework is insufficient for asset pricing and analysis of changes in risk and asset values; and introducing a unified approach to asset pricing that simultaneously considers six factors, and the conditions under which this approach will work; iii) explaining why leisure, taxes and housing are equally as important as consumption and investment in asset pricing; iv) introducing the Marginal Rate of Intertemporal Joint Substitution (MRIJS) among Consumption, Taxes, Investment, Leisure, Intangibles and Housing - this model incorporates Regret Theory and captures features of reality that dont fit well into standard asset pricing models, and this framework can support specific or very general finance theories and or very complicated models; v) showing why the Elasticity of Intertemporal Substitution (EIS) is inaccurate and is insufficient for asset pricing and analysis of investor preferences.