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
