Asset Pricing with Downside Risk Aversion with Luciano de Castro

Wednesday, Jan. 24 at 1:00 p.m.

Please join us in-person or via Zoom as we welcome Luciano I. de Castro, Henry B. Tippie Research Fellow and Professor at the University of Iowa. He will discuss his new paper, which proposes a new asset pricing model that departs from the standard one by focusing on downside risk aversion using quantile preferences. In this model, a consumer maximizes the τ-quantile (instead of the expectation) of the discounted stream of the utility of consumption financed by investing in assets. The parameter τ ∈ (0, 1) determines the downside risk aversion, while the concavity of the utility function is exclusively related to the elasticity of intertemporal substitution (EIS). Thus, the model allows for a clear separation of the asset pricing effect of risk aversion from that of EIS. We show that an asset is priced as the τ-quantile of the present value of future dividends, discounted by the usual stochastic discount factor. The riskfree rate and the equity premium depend on both consumption risk and market risk, and the price of risk is a function of the risk attitude, captured by τ, and the EIS. Within a reasonable range of parameter values, the equity premium is mainly driven by the risk attitude while the riskfree rate is mainly driven by EIS. We take the model to the data and find that it can fit the observed equity premium and riskfree rate with reasonable preference parameters. In other words, the equity premium does not lead to a puzzle in this model.

Location: CBA 3.202 Legacy Events Room, 2110 Speedway, Austin, TX 78705