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The Impact of Individual Loss Aversion on Market Risk-Return Trade-off: A Non-linear Approach

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  • Shoka Hayaki

    (Faculty of Economics, Kagawa University and Research Institute for Economics and Business Administration, Kobe University, JAPAN)

Abstract

Traditional frameworks often fail to adequately explain the observed procyclical nature of the risk-return trade-off associated with aggregate risk aversion in recent years. This study introduces a simple model incorporating the concepts of loss aversion and state-dependent preferences. The model suggests an initial positive adjustment to the risk-return trade-off when the shock occurs, followed by a negative adjustment once the shock fully manifests. Essentially, the risk-return trade-off temporarily becomes procyclical as the shock spreads. In this study, the nonlinear structure of the risk-return trade-off is approximated using natural cubic splines with several constraints. Estimation results based on market excess returns in the United States indicate that a nonlinear risk-return trade-off, consistent with the model, offers valuable insights for pricing.

Suggested Citation

  • Shoka Hayaki, 2024. "The Impact of Individual Loss Aversion on Market Risk-Return Trade-off: A Non-linear Approach," Discussion Paper Series DP2024-05, Research Institute for Economics & Business Administration, Kobe University.
    • Handle: RePEc:kob:dpaper:dp2024-05
    as

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    File URL: https://www.rieb.kobe-u.ac.jp/academic/ra/dp/English/DP2024-05.pdf
    File Function: First version, 2024
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    References listed on IDEAS

    as
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