Generalized asset pricing: Expected Downside Risk-Based Equilibrium Modelling

TL;DR

This paper develops a new equilibrium asset pricing model using a nonparametric risk measure, Expected Downside Risk (EDR), combined with Prospect Theory to better reflect realistic investor behavior and improve return predictions.

Contribution

It introduces a novel risk measure, EDR, and integrates it with Prospect Theory to create a more realistic and flexible asset pricing model that overcomes common assumptions of prior models.

Findings

Model accurately predicts equilibrium expected returns.

Inclusion of EDR improves model realism.

Empirical evidence supports the model's effectiveness.

Abstract

We introduce an equilibrium asset pricing model, which we build on the relationship between a novel risk measure, the Expected Downside Risk (EDR) and the expected return. On the one hand, our proposed risk measure uses a nonparametric approach that allows us to get rid of any assumption on the distribution of returns. On the other hand, our asset pricing model is based on loss-averse investors of Prospect Theory, through which we implement the risk-seeking behaviour of investors in a dynamic setting. By including EDR in our proposed model unrealistic assumptions of commonly used equilibrium models - such as the exclusion of risk-seeking or price-maker investors and the assumption of unlimited leverage opportunity for a unique interest rate - can be omitted. Therefore, we argue that based on more realistic assumptions our model is able to describe equilibrium expected returns with higher accuracy, which we support by empirical evidence as well.