RIEB Discussion Paper Series No.2024-05

Title

The Impact of Individual Loss Aversion on Market Risk-Return Trade-off: A Non-linear Approach

Abstract

Traditional frameworks often fail to adequately explain the observed procyclical nature of the risk-return trade-off associated with aggregate risk aversion in recent years. This study introduces a simple model incorporating the concepts of loss aversion and state-dependent preferences. The model suggests an initial positive adjustment to the risk-return trade-off when the shock occurs, followed by a negative adjustment once the shock fully manifests. Essentially, the risk-return trade-off temporarily becomes procyclical as the shock spreads. In this study, the nonlinear structure of the risk-return trade-off is approximated using natural cubic splines with several constraints. Estimation results based on market excess returns in the United States indicate that a nonlinear risk-return trade-off, consistent with the model, offers valuable insights for pricing.

Inquiries

Shoka HAYAKI
Faculty of Economics, Kagawa University
Research Institute for Economics and Business Administration
Kobe University
Rokkodai-cho, Nada-ku, Kobe
657-8501 Japan
Phone: +81-78-803-7036
FAX: +81-78-803-7059