Bryan R. Routledge

Generalized Disappointment Aversion and Asset Prices
Bryan R. Routledge, Carnegie Mellon University
Stanley E. Zin, Carnegie Mellon University and NBER
October 2004
(Note: NBER Working Paper No.w10107 is an older version)

We provide an axiomatic preference-based model of asset-pricing based on an extension of Gul (1991)``A Theory of Disappointment Aversion'' disappointment aversion model. By introducing a more flexible definition of the endogenous disappointment threshold, our Generalized Disappointment Aversion (GDA) preferences focus risk-preferences more explicitly on tail events. This is consistent with both experimental evidence such as Allais' paradox as well as common risk-management practices such as ``value at risk." We show in a Lucas-tree economy that GDA risk preferences are a substantial improvement over both the disappointment aversion and expected utility models. In particular, since disappointment effects are endogenously state-dependent, GDA preferences generate effective risk aversion that is counter-cyclical. In addition, the model also produces a large equity premium and a risk-free rate that is pro-cyclical and has low volatility.

Keywords:}Equity premium puzzle, Asset Returns, Risk Preference, Recursive Utility, Independence Axiom, counter cyclical risk aversion

Data updated: 11.02.2004 11:33

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