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Generalized Disappointment Aversion and Asset Prices

  • Bryan R. Routledge
  • Stanley E. Zin

We provide an axiomatic model of preferences over atemporal risks that generalizes Gul (1991) A Theory of Disappointment Aversion' by allowing risk aversion to be first order' at locations in the state space that do not correspond to certainty. Since the lotteries being valued by an agent in an asset-pricing context are not typically local to certainty, our generalization, when embedded in a dynamic recursive utility model, has important quantitative implications for financial markets. We show that the state-price process, or asset-pricing kernel, in a Lucas-tree economy in which the representative agent has generalized disappointment aversion preferences is consistent with the pricing kernel that resolves the equity-premium puzzle. We also demonstrate that a small amount of conditional heteroskedasticity in the endowment-growth process is necessary to generate these favorable results. In addition, we show that risk aversion in our model can be both state-dependent and counter-cyclical, which empirical research has demonstrated is necessary for explaining observed asset-pricing behavior.

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File URL: http://www.nber.org/papers/w10107.pdf
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Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10107.

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Date of creation: Nov 2003
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Publication status: published as Bryan R. Routledge & Stanley E. Zin, 2010. "Generalized Disappointment Aversion and Asset Prices," Journal of Finance, American Finance Association, vol. 65(4), pages 1303-1332, 08.
Handle: RePEc:nbr:nberwo:10107
Note: AP
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  1. Nicholas BARBERIS & Ming HUANG & Tano SANTOS, 2000. "Prospect Theory and Asset Prices," FAME Research Paper Series rp16, International Center for Financial Asset Management and Engineering.
  2. Nicholas Barberis & Ming Huang, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," NBER Working Papers 8190, National Bureau of Economic Research, Inc.
  3. Larry G. Epstein & Stanley E. Zin, 1991. "The Independence Axiom and Asset Returns," NBER Technical Working Papers 0109, National Bureau of Economic Research, Inc.
  4. Bekaert, G.R.J. & Hodrick, R. & Marshall, D., 1997. "The implications of first-order risk aversion for asset market risk premiums," Discussion Paper 1997-07, Tilburg University, Center for Economic Research.
  5. Ang, Andrew & Bekaert, Geert & Liu, Jun, 2005. "Why stocks may disappoint," Journal of Financial Economics, Elsevier, vol. 76(3), pages 471-508, June.
  6. Angelo Melino & Alan X. Yang, 2003. "State Dependent Preferences Can Explain the Equity Premium Puzzle," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 6(4), pages 806-830, October.
  7. Basak, Suleyman & Shapiro, Alexander, 2001. "Value-at-Risk-Based Risk Management: Optimal Policies and Asset Prices," Review of Financial Studies, Society for Financial Studies, vol. 14(2), pages 371-405.
  8. Nicholas Barberis, 2001. "Mental Accounting, Loss Aversion, and Individual Stock Returns," Journal of Finance, American Finance Association, vol. 56(4), pages 1247-1292, 08.
  9. Gul, Faruk, 1991. "A Theory of Disappointment Aversion," Econometrica, Econometric Society, vol. 59(3), pages 667-86, May.
  10. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  11. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
  12. Backus, David K. & Gregory, Allan W. & Zin, Stanley E., 1989. "Risk premiums in the term structure : Evidence from artificial economies," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 371-399, November.
  13. Epstein, Larry G & Zin, Stanley E, 1989. "Substitution, Risk Aversion, and the Temporal Behavior of Consumption and Asset Returns: A Theoretical Framework," Econometrica, Econometric Society, vol. 57(4), pages 937-69, July.
  14. Kahneman, Daniel & Tversky, Amos, 1979. "Prospect Theory: An Analysis of Decision under Risk," Econometrica, Econometric Society, vol. 47(2), pages 263-91, March.
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