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Generalized Disappointment Aversion, Learning, and Asset Prices

Mykola Babiak

CERGE-EI Working Papers from The Center for Economic Research and Graduate Education - Economics Institute, Prague

Abstract: This paper provides a generalized disappointment aversion (GDA) interpretation of the variance and skew risk premia in equity returns and the volatility skew in equity index options. The key ingredients are Bayesian learning about a hidden con- sumption growth rate and the investor's tail aversion induced by GDA preferences which amplify the impact of consumption shocks. This model with disappointment risk reproduces salient properties of the variance and skew risk premia and generates a realistic volatility skew implied by index options, while simultaneously matching the mean and volatility of risk-free rate and equity returns, and the level of the price-dividend ratio. Additionally, the time-varying probability of disappointment events generates a wide range of dynamic asset pricing phenomena.

Keywords: equity premium; variance and skew risk premia; volatility skew; generalized disappointment aversion; learning; Markov switching (search for similar items in EconPapers)
JEL-codes: D81 E32 E44 G12 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-mac, nep-rmg and nep-upt
Date: 2017-10
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