Generalized Disappointment Aversion, Long-run Volatility Risk, and Asset Prices

Abstract

We propose an asset pricing model where preferences display generalized disappointment aversion (Routledge and Zin, 2009) and the endowment process involves long-run volatility risk. These preferences, which are embedded in the Epstein and Zin (1989) recursive utility framework, overweight disappointing results as compared to expected utility, and display relatively larger risk aversion for small gambles. With a Markov switching model for the endowment process, we derive closed-form solutions for all returns moments and predictability regressions. The model produces first and second moments of price-dividend ratios and asset returns and return predictability patterns in line with the data. Compared to Bansal and Yaron (2004), we generate: i) more predictability of excess returns by price-dividend ratios; ii) less predictability of consumption growth rates by price-dividend ratios. Differently from the Bansal and Yaron model, our results do not depend on a value of the elasticity of intertemporal substitution greater than one.

Jump-Diffusion Long-Run Risks Models, Variance Risk Premium, and Volatility Dynamics*

“…Hansen and Sargent (2010) suggest that the long-run risk assumption may originate from the model uncertainty of investors. Bonomo et al (2011) propose that the low predictability in consumption growth can be explained by generalized disappointment aversion. More research is needed in the future to enlighten our understanding of the sources of long-run risks in consumption growth.…”

Asset pricing with Second-Order Esscher Transforms

“…Indeed, this form naturally stands out in equilibrium models like CCAPM (see e.g. Cochrane, 2005), consumption-based asset pricing models with habit formation or with Epstein-Zin preferences (see, among others, Bansal and Yaron, 2004;Campbell and Cochrane, 1999;Bonomo et al, 2011;Garcia et al, 2006). Moreover, in general continuous-time security market models the discretized version of the SDF is exponential-affine (see Gourieroux and Monfort, 2007).…”

“…f, having the classical Esscher Transform as a subset (see Gerber and Shiu, 1994). This new family, that we call Second-Order Esscher Transforms and which is built upon the concept of Second-Order Laplace Transform, gives the possibility, for instance, to modify not only the mean but also the variance-covariance matrix of a multivariate Gaussian distribution or the mean and the variance-covariance 1 See, among others, Bansal and Yaron (2004), Bertholon et al (2006), Campbell and Cochrane (1999), Darolles et al (2006), Bonomo et al (2011), Gourieroux et al (2009Gourieroux et al ( , 2006, Monfort and Pegoraro (2007), and Stutzer (1995).…”

Ambiguity in the Cross-Section of Expected Returns: An Empirical Assessment

“…To enable a comparison of the preference parameters of an ambiguity averse and an ambiguity neutral DM, we define the term effective risk aversion as the coefficient of relative risk aversion that yields the same certainty equivalent corresponding to the unconditional probability measure as an ambiguity averse DM that distinguishes between conditional and unconditional probability measures. This definition is motivated by Bonomo et al (2011), who considered a similar notion for generalized disappointment aversion risk preferences, as defined by Routledge and Zin (2010).…”