TY - JOUR

T1 - Generalized Disappointment Aversion and the Variance Term Structure

AU - Babiak, Mykola

PY - 2023/3/27

Y1 - 2023/3/27

N2 - 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.

AB - 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.

KW - Generalized Disappointment Aversion

KW - Learning

KW - Price of Variance Risk

KW - Rare Events

U2 - 10.1017/S0022109023000364

DO - 10.1017/S0022109023000364

M3 - Journal article

SP - 1

EP - 25

JO - Journal of Financial and Quantitative Analysis

JF - Journal of Financial and Quantitative Analysis

SN - 0022-1090

ER -