Downside Risks and the Price of Variance Uncertainty
65 Pages Posted: 13 Feb 2018 Last revised: 18 Nov 2019
Date Written: February 28, 2018
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: Suggested Citation