An Asset Pricing Model for Mean-Variance-Downside-Risk Averse Investors

Jose Olmo

No 07/01, City University Economics Discussion Papers from Department of Economics, City University, London

Abstract: We introduce a family of utility functions that describe the preferences of mean-variance-downside-risk (mvdr) averse investors. The risk premium on a risky asset in an economy with these individuals is given by a weighted sum of CAPM systematic risk and a systematic risk given by the level of comovements between the asset and the market in distress episodes. Hence investors require a higher reward than predicted by CAPM for holding assets correlated with the market in distress episodes, and a lower reward for holding assets with negative correlation in market downturns. The application of this pricing theory to financial sectors in FTSE-100 is illuminating. The empirical failure of standard CAPM is explained by the extra reward required by investors from market downturns. While Chemicals and Mining sectors exhibit positive comovements with FTSE downturns; Banking and Oil and Gas sectors are robust to them and Telecommunications Services exhibit negative comovements serving as refugee of investors fleeing from domestic market distress episodes.

Keywords: Asset Pricing; CAPM; Downside-risk; Mean-variance (search for similar items in EconPapers)
JEL-codes: G11 G12 G13 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cfn, nep-fmk, nep-rmg and nep-upt
Date: 2007-01
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Persistent link: http://EconPapers.repec.org/RePEc:cty:dpaper:07/01

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