State Dependence Can Explain the Risk Aversion Puzzle

The pricing kernel puzzle: survey and outlook

“…Extending this work, Chabi-Yo, Garcia, and Renault (2008) show that the pricing kernel puzzle can be explained by regime-switches in some latent state variable, which in turn drives fundamentals (the joint distribution of the pricing kernel and returns), preferences, or beliefs. Their model uses a recursive Epstein-Zin (1989) utility for modeling the first two aspects (fundamentals and preferences), and an external habit model, which is based on Veronesi (2004) andCampbell andCochrane (1999), for modeling the third aspect (beliefs).…”

“…The jumps are again driven by a regime-switching process as in Chabi-Yo, Garcia, and Renault (2008); a modeling choice which allows consumption itself to stay relatively smooth. However, the learning aspect is the most exciting contribution of the model.…”

Option Pricing Under Time-Varying Risk-Aversion with Applications to Risk Forecasting

“…In particular, their model allows to produce S-shaped pricing kernels. Similarly, Benzoni et al [25] and Chabi-Yo et al [52] consider consumption-based models, where the representative investor has state-dependent utility, so that his risk aversion depends on the wealth level, which in turn allows to produce S-shaped pricing kernels. Most notably in this context is the contribution of Hens and Reichlin [94], who show that by relaxing one of the three standard assumptions -complete markets, averse investors and correct beliefs -pricing kernels can exhibit increasing regions.…”

The Puzzle of Index Option Returns

“…Chabi-Yo, Garcia, and Renault (2008) introduced latent state variables upon which then fundamental variables or preferences in turn might depend. Alternatively, Bates (2008) included the number of stock markets crashes as a state variable.…”