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Heterogeneity in Beliefs and Volatility Tail Behavior

Published online by Cambridge University Press:  24 February 2016

Gurdip Bakshi ,
Dilip Madan  and
George Panayotov
Gurdip Bakshi*
Affiliation:
gbakshi@rhsmith.umd.edu, University of Maryland, Smith School of Business, College Park, MD 20742
Dilip Madan
Affiliation:
dbm@rhsmith.umd.edu, University of Maryland, Smith School of Business, College Park, MD 20742
George Panayotov
Affiliation:
panayotov@ust.hk, Hong Kong University of Science and Technology, School of Business, Clearwater Bay, Hong Kong.
*
*Corresponding author: gbakshi@rhsmith.umd.edu
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Abstract

We propose a model of volatility tail behavior in which investors display aversion to both low-volatility and high-volatility states, and hence, the derived pricing kernel exhibits an increasing and decreasing region in the volatility dimension. The model features investors who have heterogeneity in beliefs about volatility outcomes and maximize their utility by choosing volatility-contingent cash flows. Our empirical examination suggests that the model is better suited to reproduce data features in the left tail of the volatility distribution, both qualitatively and quantitatively.

Type
Research Articles
Information
Journal of Financial and Quantitative Analysis , Volume 50 , Issue 6 , December 2015 , pp. 1389 - 1414
Copyright
Copyright © Michael G. Foster School of Business, University of Washington 2016 

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