Generalized Disappointment Aversion and Asset Prices

Abstract

We provide an axiomatic model of preferences over atemporal risks that generalizes Gul (1991) A Theory of Disappointment Aversion' by allowing risk aversion to be first order' at locations in the state space that do not correspond to certainty. Since the lotteries being valued by an agent in an asset-pricing context are not typically local to certainty, our generalization, when embedded in a dynamic recursive utility model, has important quantitative implications for financial markets. We show that the state-price process, or asset-pricing kernel, in a Lucas-tree economy in which the representative agent has generalized disappointment aversion preferences is consistent with the pricing kernel that resolves the equity-premium puzzle. We also demonstrate that a small amount of conditional heteroskedasticity in the endowment-growth process is necessary to generate these favorable results. In addition, we show that risk aversion in our model can be both state-dependent and counter-cyclical, which empirical research has demonstrated is necessary for explaining observed asset-pricing behavior.