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Whence GARCH? A Preference-Based Explanation for Conditional Volatility

Grant Richard McQueen
Brigham Young University - Department of Business Management

Keith Vorkink
Brigham Young University - J. Willard and Alice S. Marriott School of Management

December 12, 2003

Abstract:
We develop a preference-based equilibrium asset pricing model that explains low frequency conditional volatility. Similar to Barberis, Huang, and Santos (2001), agents in our model care about wealth changes, experience loss aversion, and keep a mental scorecard that affects their level of risk aversion. A new feature of our model is that when perturbed by unexpected returns, investors become temporarily more sensitive to news. Gradually, investors become accustomed to the new level of wealth, restoring prior levels of risk aversion and news sensitivity. The state-dependent sensitivity to news creates the type of volatility clustering found in low frequency stock returns. We find empirical support for our model's predictions that relate the scorecard to conditional volatility and skewness.

JEL Classifications: C22, G12

Working Paper Series

Date posted: December 13, 2002 ; Last revised: December 15, 2003

Suggested Citation

McQueen, Grant Richard and Vorkink, Keith, Whence GARCH? A Preference-Based Explanation for Conditional Volatility (December 12, 2003). Available at SSRN: http://ssrn.com/abstract=354020 or doi:10.2139/ssrn.354020

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Contact Information

Keith Vorkink (Contact Author) Brigham Young University - J. Willard and Alice S. Marriott School of Management ( email ) Provo, UT 84602 United States
Grant R. McQueen Brigham Young University - Department of Business Management ( email ) TNRB 660 Provo, UT 84602 United States 801-422-3017 (Phone)