Great Expectations, Greater Disappointment: Disappointment Aversion Preferences in General Equilibrium Asset Pricing Models.

For a long time, most financial economists have largely ignored experimental evidence on decision making under risk, mainly because introducing behavioral elements into asset pricing models while preserving investor rationality is a very challenging task. This thesis focuses on a relatively novel set of preferences that exhibit attitudes toward risk termed disappointment aversion preferences. These preferences can capture well documented patterns for risky choices, such as asymmetric marginal utility over gains and losses, without violating first-order stochastic dominance, transitivity of preferences or aggregation of investors. In my dissertation, I employ disappointment aversion preferences in an attempt to resolve two of the most prominent puzzles in asset pricing: the equity premium puzzle in the cross-section of expected stock returns, and the credit spread puzzle in corporate bond markets. The first chapter of my dissertation explains the cross-section of expected stock returns for the U.S. economy using an empirically tractable solution for the disappointment aversion discount factor. The consumption-based asset pricing framework introduced in the first chapter does not rely on additional risk processes, backwards-looking state variables, or extremely persistent macroeconomic shocks to generate large equity risk premia. In contrast, estimation results highlight the importance of disappointment events, defined as periods during which consumption growth drops below its forward-looking certainty equivalent. Finally, the disappointment aversion model can generate smaller in- and out-of-sample pricing errors than popular factor-based models using aggregate consumption growth as the only independent variable. Structural models of default are unable to generate measurable Baa-Aaa credit spreads, when these models are calibrated to realistic values for default rates and losses given default. Motivated by recent results in behavioral economics, the second chapter proposes a consumption-based asset pricing model with disappointment aversion preferences in an attempt to resolve the credit spread puzzle. Simulation results suggest that as long as losses given default and default boundaries are countercyclical, then the disappointment model can resolve the Baa-Aaa credit spread puzzle using preference parameters that are consistent with experimental findings. Further, the disappointment aversion discount factor can almost perfectly match key moments for stock market returns, the price-dividend ratio, and the risk-free rate.PHDBusiness AdministrationUniversity of Michigan, Horace H. Rackham School of Graduate Studieshttp://deepblue.lib.umich.edu/bitstream/2027.42/99981/1/sdeli_1.pd

A Single-Factor Consumption-Based Asset Pricing Model

We propose a single-factor asset pricing model based on an indicator function of consumption growth being less than its endogenous certainty equivalent. This certainty equivalent is derived from generalized disappointment-aversion preferences, and it is located approximately 1 standard deviation below the conditional mean of consumption growth. Our single-factor model can explain the cross section of expected returns for size, value, reversal, profitability, and investment portfolios at least as well as the Fama–French multifactor models. Our results show strong empirical support for asymmetric preferences and question the effectiveness of the smooth utility framework, which is traditionally used in consumption-based asset pricing

Do Investment-Based Models Explain Equity Returns? Evidence from Euler Equations

Abstract We investigate the empirical implications of the investment-based model of asset pricing for the Hansen-Jagannathan and Kozak-Nagel-Santosh discount factors in the linear span of equity returns. We find that the stochastic discount factors satisfying the Euler equation for equity returns cannot satisfy the Euler equation for investment returns because returns on corporate investment covary inversely with the sources of equity risk relative to returns on equity. As a result, the model fails to replicate the level of the risk premium. Our results suggest that joint restrictions on the optimality of investment and consumption pose stringent conditions for candidate production models

Backorder penalty cost coefficient "b": What could it be?

The classical economic order quantity (EOQ) model with planned penalized backorders (PB) relies on postulating a value for the backorder penalty cost coefficient, b, which is supposed to reflect the intangible adverse effect of the future loss of customer goodwill following a stockout. Recognizing that the effect of the future loss of customer goodwill should be not a direct penalty cost but a change in future demand, Schwartz [1966. A new approach to stockout penalties. Management Science 12(12), B538-B544] modified the classical EOQ-PB model by eliminating the backorder penalty cost term from the objective function and assuming that the long-run demand rate is a decreasing, strictly convex function of the customer's "disappointment factor" (defined as the complement of the demand fill rate) following a stockout, which in turn is an increasing, strictly convex function of the demand fill rate. He called the new model a perturbed demand (PD) model. Schwartz provided convincing justification for his PD model and presented several variations of it in a follow-up paper, but he did not solve any of these models. In this paper, we solve Schwartz's original PD model and its variations, and we discuss the implications of their solutions, thus filling a gap in the literature left by Schwartz. Moreover, having been convinced that Schwartz's approach is more valid than the classical approach for representing the effect of the loss of customer goodwill following a stockout, but also recognizing that the classical approach is far more popular than the PD approach, because of its simplicity and because of tradition, we use the solution of the PD model to infer the value of b in the classical model, thus providing one possible answer to the question, what could b be? A noteworthy implication of the solution of Schwartz's original PD model is that the optimal fill rate is always 0 or 1, rendering the inferred value of b in the classical model 0 or [infinity], respectively. Suspecting that the property of the PD function which is most likely responsible for producing this "bang-bang" type of result is strict convexity, we show that for the case where the PD function is proportional to an integer power, say n, of the fill rate, the optimal fill rate is always 0 or 1, if and only if n>1, in which case the PD function is strictly convex in the fill rate.Economic order quantity Stockout Backorders Perturbed demand

Underreaction to political information and price momentum

In this study, we examine whether momentum in stock prices is induced by changes in the political environment. We find that momentum profits are concentrated among politically sensitive firms and industries. From 1939 to 2016, a trading strategy with a long position in winner portfolios (industries or firms) that are politically unfavored and a short position in losers that are politically favored does not generate significant momentum profits. Furthermore, our political‐sensitivity‐based long‐short portfolio explains 23% to 27% (42% to 43%) of monthly stock (industry) momentum alphas. This explanatory power is concentrated around presidential elections, when the level of political activity is high. Collectively, our results suggest that investor underreaction to political information generates momentum in stock and industry returns

Geography of firms and propagation of local economic conditions

Abstract This study shows that the geographic network of public firms facilitates the propagation of local economic conditions across the United States. We identify economic connections among U.S. states based on the 10‐K listings of public firms and show that the returns and liquidity of firms headquartered in connected states exhibit excess comovement. The economic connections also generate spillover effects where the economy of a state affects its connected states and amplifies the impact of local economic conditions on the U.S. economy. In particular, a 1% production increase in a large state like California is associated with a 6.71% change in annual U.S. GDP growth, relative to average GDP growth