The Impact of Individual Loss Aversion on Market Risk-Return Trade-off: A Non-linear Approach

Hayaki, Shoka

The Impact of Individual Loss Aversion on Market Risk-Return Trade-off: A Non-linear Approach

No DP2024-05, Discussion Paper Series from Research Institute for Economics & Business Administration, Kobe University

Abstract: Traditional frameworks often fail to adequately explain the observed procyclical nature of the risk-return trade-off associated with aggregate risk aversion in recent years. This study introduces a simple model incorporating the concepts of loss aversion and state-dependent preferences. The model suggests an initial positive adjustment to the risk-return trade-off when the shock occurs, followed by a negative adjustment once the shock fully manifests. Essentially, the risk-return trade-off temporarily becomes procyclical as the shock spreads. In this study, the nonlinear structure of the risk-return trade-off is approximated using natural cubic splines with several constraints. Estimation results based on market excess returns in the United States indicate that a nonlinear risk-return trade-off, consistent with the model, offers valuable insights for pricing.

Pages: 42 pages
Date: 2024-03
New Economics Papers: this item is included in nep-rmg and nep-upt
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