Consumption-Based Asset Pricing with Loss Aversion

I incorporate loss aversion in a consumption-based asset pricing model with recursive preferences and solve for asset prices in closed-form. I find loss aversion increases expected returns substantially relative to the standard recursive utility model. This feature of my model improves the ability to match moments on asset prices. Further, I find loss aversion induces important nonlinearities into the expected excess returns as a function of the exposure to the consumption shocks. In particular, the elasticities of expected returns with respect to the exposure to the consumption shocks are greater for assets with smaller exposures to the shocks, thus generating interesting predictions for the cross-section of returns. I provide empirical evidence supporting this outcome. The model with loss aversion correctly predicts both a negative premium for skewness and a security market line, the excess returns as a function of the exposure to market risk, flatter than the CAPM.