A note on a framework to assess the required equity risk premium using cumulative prospect theory

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.