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Generalized Disappointment Aversion and the Variance Term Structure

Published online by Cambridge University Press:  27 March 2023

Mykola Babiak Open the ORCID record for Mykola Babiak [Opens in a new window]
Mykola Babiak*
Affiliation:
Lancaster University Management School
*
m.babiak@lancaster.ac.uk
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Abstract

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Contrary to leading asset pricing theories, recent empirical evidence indicates that financial markets compensate only short-term equity variance risk. An equilibrium model with generalized disappointment aversion risk preferences and rare events reconciles salient features of the variance term structure. In addition, a calibration explains the variance and skew risk premiums in equity returns and the implied volatility skew of index options while capturing standard moments of fundamentals, equity returns, and the risk-free rate. The key intuition for the results stems from substantial countercyclical risk aversion induced by endogenous variation in the probability of disappointing events in consumption growth.

Type
Research Article
Information
Journal of Financial and Quantitative Analysis , First View , pp. 1 - 25
Creative Commons
Creative Common License - CCCreative Common License - BY
This is an Open Access article, distributed under the terms of the Creative Commons Attribution licence (https://creativecommons.org/licenses/by/4.0), which permits unrestricted re-use, distribution and reproduction, provided the original article is properly cited.
Copyright
© The Author(s), 2023. Published by Cambridge University Press on behalf of the Michael G. Foster School of Business, University of Washington

Footnotes

This article is based on the first chapter of my dissertation at CERGE-EI (2019) and was previously circulated under the title “Generalized Disappointment Aversion, Learning, and Asset Prices.” I am especially indebted to Roman Kozhan for constructive suggestions that greatly improved the article. I appreciate helpful comments from Anmol Bhandari, Daniele Bianchi, Jaroslav Borovicka, Thierry Foucault (the editor), Michael Hasler, Michael Johannes, Keneth L. Judd, Marek Kapicka, Michal Kejak, Michal Pakoš, Bryan Routledge (the referee), David Schreindorfer, Veronika Selezneva, Ctirad Slavik, Sergey Slobodyan, Stijn Van Nieuwerburgh, Ansgar Walther, conference participants at the 2016 EEA-ESEM Meeting, the 2016 Meeting of the Society for Computational Economics, the 2016 Zurich Initiative for Computational Economics, the 2016 Annual Conference of the Swiss Society for Financial Market Research, the 2018 RES Annual Conference, the 2018 RES Symposium of Junior Researchers, the 2018 Spanish Economic Association Meeting, and seminar participants at Columbia Business School, Warwick Business School, Lancaster University Management School, Collegio Carlo Alberto, Durham University Business School, the University of Gothenburg, and the University of Groningen. The financial support from the Charles University Grant Agency (GAUK No. 151016) and the Czech Science Foundation Project No. P402/12/G097 (DYME Dynamic Models in Economics) is gratefully acknowledged.

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