Volatility Downside Risk
54 Pages Posted: 23 Dec 2012
Date Written: November 29, 2012
This paper derives and tests the cross-sectional predictions of an intertemporal equilibrium asset pricing model with generalized disappointment aversion and time-varying macroeconomic uncertainty. To the contrary of the existing literature, disappointment may result not only from a fall in the market index, but also from a rise in a volatility index. Theoretically, we show that besides the market return and changes in market volatility, three two-asset option-like payoffs, contingent to the disappointing event, are also priced factors: a long binary cash-or-nothing option, a short put on the market index and a long call on the volatility index. Implied measures of market and volatility downside risks similar to those considered in the literature explicitly express as linear combinations of exposures to these options and their underlying instruments. Empirically, we find that the cross-section of stock returns reflects a premium for bearing undesirable exposures to these options. The signs of the estimated risk premia are consistent with theory, their economic magnitudes show that a long/short strategy on exposure to each of these options pays on average more than 5% per annum, and these rewards are not explained by coskewness, size, value, and momentum factors.
Keywords: Generalized Disappointment Aversion, Option Payoffs, Downside Risks, Cross-Section
JEL Classification: G12, C12, C31, C32
Suggested Citation: Suggested Citation