Generalized disappointment aversion and the cross-section of stock returns

Xiaohua Lu and Yonghong Hu

Applied Economics Letters, 2023, vol. 30, issue 17, 2455-2463

Abstract: Based on Epstein and Zin’s recursive utility function, this paper integrates generalized disappointment aversion preferences to derive an intertemporal equilibrium asset pricing model (ICAPM). We show that in addition to discount-rate news, cash-flow news, and news about future risk, four factors related to disappointment are priced. These four factors are a downstate factor, discount-rate downside news, cash-flow downside news, and downside news about future risk. We find that our seven-factor model can explain the cross-section of expected returns across portfolios sorted by size, book-to-market, investment, operating profitability, and momentum. Both the seven-beta ICAPM and the restricted seven-beta ICAPM suggest that disappointment-averse investors are more sensitive to cash-flow news and cash-flow downside news than other news terms and therefore demand higher premiums. Our results show that the seven-beta ICAPM has better performance for most portfolios and provides empirical support for investors’ asymmetric preferences.

Date: 2023
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DOI: 10.1080/13504851.2022.2097636

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