Generalized Disappointment Aversion and the Variance Term Structure

Author:

Babiak MykolaORCID

Abstract

Abstract 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.

Publisher

Cambridge University Press (CUP)

Subject

Economics and Econometrics,Finance,Accounting

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