Andries, Marianne (2012) Consumption-based Asset Pricing with Loss Aversion. , Toulouse

Abstract

I incorporate loss aversion in a consumption-based asset pricing model with recursive preferences
and solve for asset prices in closed-form. I find loss aversion increases expected returns
substantially relative to the standard recursive utility model. This feature of my model improves
the ability to match moments on asset prices. Further, I find loss aversion induces
important nonlinearities into the expected excess returns as a function of the exposure to the
consumption shocks. In particular, the elasticities of expected returns with respect to the exposure
to the consumption shocks are greater for assets with smaller exposures to the shocks,
thus generating interesting predictions for the cross-section of returns. I provide empirical
evidence supporting this outcome. The model with loss aversion 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.