Generalized Disappointment Aversion and the Variance Term Structure

Mykola Babiak

Journal of Financial and Quantitative Analysis, 2024, vol. 59, issue 4, 1796-1820

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.

Date: 2024
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