Downside Consumption Risk and Expected Returns

Abstract:     
The expected utility model captures the attitude toward risk exclusively through the marginal utility. Recognizing this limitation several models explicitly account for aversion to downside risk. This paper presents non-experimental evidence that this feature is empirically relevant in asset pricing.

I use rank-dependent expected utility to model aversion to downside risk and derive Euler equations for consumption and asset returns. The resulting model nests the standard CCAPM and allows estimation of preferences parameters by GMM and the tests of significance of the downside risk aversion. I estimate the model using Fama and French 25 portfolios and find that it performs considerably better than the standard CCAPM. The parameter estimates imply that the left tail outcomes are over-weighted while the right tail outcomes are under-weighted. Asset prices reflect a sizable premium for downside risk and the corresponding parameter is strongly significant. The downside risk premium exhibits significant variation across the test portfolios and contributes to value and size premia.

Keywords: Donwside risk, Consumption-based asset pricing, rank-dependent utility

JEL Classifications: G12

Working Paper Series