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Generalized Disappointment Aversion, Learning, and Asset Prices

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  • Mykola Babiak

Abstract

This paper provides a generalized disappointment aversion (GDA) interpretation of the variance and skew risk premia in equity returns and the volatility skew in equity index options. The key ingredients are Bayesian learning about a hidden con- sumption growth rate and the investor's tail aversion induced by GDA preferences which amplify the impact of consumption shocks. This model with disappointment risk reproduces salient properties of the variance and skew risk premia and generates a realistic volatility skew implied by index options, while simultaneously matching the mean and volatility of risk-free rate and equity returns, and the level of the price-dividend ratio. Additionally, the time-varying probability of disappointment events generates a wide range of dynamic asset pricing phenomena.

Suggested Citation

  • Mykola Babiak, 2017. "Generalized Disappointment Aversion, Learning, and Asset Prices," CERGE-EI Working Papers wp606, The Center for Economic Research and Graduate Education - Economics Institute, Prague.
    • Handle: RePEc:cer:papers:wp606
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    References listed on IDEAS

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    More about this item

    Keywords

    equity premium; variance and skew risk premia; volatility skew; generalized disappointment aversion; learning; Markov switching;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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