Bonomo, Marco, Garcia, René, Meddahi, Nour and Tédongap, Roméo (2011) Generalized Disappointment Aversion, Long Run Volatility Risk and Asset Prices. Review of Financial Studies, 24 (1). pp. 82-122.

Abstract

We propose an asset pricing model where preferences display generalized disappointment
aversion (Routledge and Zin, 2009) and the endowment process involves long-run volatility
risk. These preferences, which are embedded in the Epstein and Zin (1989) recursive utility framework, overweight disappointing results as compared to expected utility, and display
relatively larger risk aversion for small gambles. With a Markov switching model for the endowment process, we derive closed-form solutions for all returns moments and predictability
regressions. The model produces first and second moments of price-dividend ratios and asset
returns and return predictability patterns in line with the data. Compared to Bansal and
Yaron (2004), we generate: i) more predictability of excess returns by price-dividend ratios; ii)
less predictability of consumption growth rates by price-dividend ratios. Differently from the
Bansal and Yaron model, our results do not depend on a value of the elasticity of intertemporal
substitution greater than one.

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