Consumption-Based Asset Pricing with Loss Aversion

Abstract

In this paper, I incorporate loss aversion features in a consumption-based asset pricing model. I define new preferences with loss aversion that allow me to solve the asset pricing model with recursive utility in closed-form. I find that even small parameters of loss aversion increase risk prices substantially relative to the standard recursive utility model (level effect). This feature of my model improves on the calibration of the standard consumption-based asset pricing model with recursive utility. I also find that in the model with loss aversion, contrarily to the standard recursive utility model, risk prices vary with risk exposure (cross-sectional effect). This differentiating feature of my model is supported by the data in that it correctly predicts both a negative premium for skewness and a security market line, the excess returns as a function of the exposure to market risk, flatter than the CAPM.

The Term Structure of the Price of Variance Risk

“…While the long-run-risk model of Bansal et al (2013) as well as the rare-disaster model of Wachter (2013) correctly predict a negative price per unit of variance risk, the models cannot quantitatively match its decline with maturity (in absolute value). Consumption-based asset pricing models with loss aversion, such as Andries (2012) and Curatola (2014), predict a pricing per unit of risk that declines intrinsically (in absolute value) with the quantity of risk, consistent with the evidence on markets where the declines in Sharpe ratios in the term-structure are accompanied by increases in volatility (see van Binsbergen and Koijen, 2015 for examples). However, our results highlight a decline in both the pricing and quantity of risk in the term-structure and cannot be simply rationalized by first-order risk aversion.…”

Thirty Years of Prospect Theory in Economics: A Review and Assessment

“…The work that has followed their paper has instead focused on formalizing the original argument (for example, Barberis, Huang, and Santos 2001;Andries 2012;). …”

Expectations-Based reference-Dependent Preferences and Asset Pricing

“…Moreover, the extended model correctly predicts the risk-free rate volatility. The model's performance is thus comparable with those of Barberis, Huang, and Santos (2001), Yogo (2008), and Andries (2013). Further, the news-utility consumption-wealth ratio is no longer i.i.d., but reaches about a third of the persistence found in Lettau and Ludvigson (2005), though less than reported in Yogo (2008).…”

“…Because the agent is loss averse with respect to a fraction of the gamble's certainty equivalent, he is not necessarily "at the kink" in high or low-consumption situations. The assetpricing theories based on prospect theory (Barberis, Huang, and Santos 2001;Benartzi and Thaler 1995;Yogo 2008;Andries 2013) imply plausible attitudes towards small and large wealth gambles. However, Barberis, Huang, and Santos (2001), Benartzi 19.…”