Downside Risks and the Price of Variance Uncertainty

This paper studies the role of generalized disappointment aversion (GDA) in reconciling several asset-pricing puzzles in models of long-run risks. To fully capture the nonlinearities introduced by these preferences, we solve the model globally with projection. This allows us to scrutinize the channels through which GDA unfolds. A key feature of our calibrated model is the significant wedge GDA drives between the physical and the risk-neutral measure. The model captures not only the size of the variance risk premium (VRP), but also the hump-shaped predictability pattern and the prominent role of downside risks for the VRP and its predictive power