Stochastic dominance : an overall review with empirical applications

Abstract

This paper presents all the Stochastic Dominance (SD) rules (in cluding Markowitz and Prospect SD Rule), situations relating to these rules such as arbitrage, and several classes of preferences consistent to the SD ap proach. It also contains various algorithms for testing SD relations and neces sary and su¢ cient conditions that may improve the e¢ ciency of each SD Rule. Finally, it is examined the existence of the well-known equity premium puz zle in several economic environments, under di¤erent economic conditions and varying time horizons. The analysis is developed in a Stochastic Dominance framework using original evidence from three markets: US, UK and Germany market. The results show that stocks stochastically dominate bonds at second order (and at any higher order) for any time horizon, under di¤erent economic situations for all international markets (US, UK, Germany). This implies that stocks outperform bonds in a great percentage and the equity premium puzzle is real and robust.