Downside Risks and the Cross-Section of Asset Returns

88 Pages Posted: 10 Feb 2017 Last revised: 2 Mar 2017

Adam Farago

Göteborg University - Center For Finance

Roméo Tédongap

ESSEC Business School Paris-Singapore

Date Written: February 28, 2017

Abstract

In an intertemporal equilibrium asset pricing model featuring disappointment aversion and changing macroeconomic uncertainty, we show that besides the market return and market volatility, three disappointment-related factors are also priced: a downstate factor, a market downside factor, and a volatility downside factor. We find that expected returns on various asset classes reflect premiums for bearing undesirable exposures to these factors. The signs of estimated risk premiums are consistent with the theoretical predictions. Our most general, five-factor model is very successful in jointly pricing stock, option, and currency portfolios, and provides considerable improvement over nested specifications previously discussed in the literature.

Keywords: Generalized Disappointment Aversion, Downside Risks, Cross-Section

JEL Classification: G12, C12, C31, C32

Suggested Citation

Farago, Adam and Tédongap, Roméo, Downside Risks and the Cross-Section of Asset Returns (February 28, 2017). Journal of Financial Economics (JFE), Forthcoming. Available at SSRN: https://ssrn.com/abstract=2914134

Adam Farago

Göteborg University - Center For Finance ( email )

Box 640
Gothenburg, 403 50
Sweden

Roméo Tédongap (Contact Author)

ESSEC Business School Paris-Singapore ( email )

Avenue Bernard Hirsch
BP 105 Cergy Cedex, 95021
France
+33134439734 (Phone)
+33134439734 (Fax)

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