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Journal of Financial and Quantitative Analysis Vol. 59 No. 4 2024

Generalized Disappointment Aversion and the Variance Term Structure

Mykola Babiak

Lancaster University

open access

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.

DOI
10.1017/s0022109023000364
Volume
59
Issue
4
Pages
1796-1820
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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