Downside Risks and the Price of Variance Uncertainty

65 Pages Posted: 13 Feb 2018 Last revised: 27 Jun 2019

See all articles by Friedrich Lorenz

Friedrich Lorenz

University of Muenster - Finance Center Muenster

Malte Schumacher

University of Zurich - Department of Business Administration

Date Written: February 28, 2018

Abstract

This paper studies the role of generalized disappointment aversion (GDA) in reconciling several asset-pricing puzzles in models of long-run risks. To fully capture the nonlinearities introduced by these preferences, we solve the model globally with projection. This allows us to scrutinize the channels through which GDA unfolds. A key feature of our calibrated model is the significant wedge GDA drives between the physical and the risk-neutral measure. The model captures not only the size of the variance risk premium (VRP), but also the hump-shaped predictability pattern and the prominent role of downside risks for the VRP and its predictive power.

Keywords: Downside Risks, Variance Risk Premium, Generalized Disappointment Aversion

JEL Classification: C68, G12, G41

Suggested Citation

Lorenz, Friedrich and Schumacher, Malte, Downside Risks and the Price of Variance Uncertainty (February 28, 2018). Available at SSRN: https://ssrn.com/abstract=3116676 or http://dx.doi.org/10.2139/ssrn.3116676

Friedrich Lorenz

University of Muenster - Finance Center Muenster ( email )

Schlossplatz 2
Muenster
Germany

Malte Schumacher (Contact Author)

University of Zurich - Department of Business Administration ( email )

Rämistrasse 71
Zurich, CH-8006
Switzerland

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