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RFS Advance Access originally published online on March 26, 2004
Review of Financial Studies 2004 17(4):915-949; doi:10.1093/rfs/hhh008
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The Review of Financial Studies Vol. 17, No. 4 © 2004 The Society for Financial Studies; all rights reserved.

Whence GARCH? A Preference-Based Explanation for Conditional Volatility

Grant McQueen
Brigham Young University

Keith Vorkink
Brigham Young University

Address correspondence to Keith Vorkink, Business Management Department, Marriott School of Management, Provo, UT 84602, or e-mail: keith_vorkink@byu.edu.

We develop a preference-based equilibrium asset pricing model that explains low-frequency conditional volatility. Similar to Barberis, Huang, and Santos (2001), agents in our model care about wealth changes, experience loss aversion, and keep a mental scorecard that affects their level of risk aversion. A new feature of our model is that when perturbed by unexpected returns, investors become temporarily more sensitive to news. Gradually investors become accustomed to the new level of wealth, restoring prior levels of risk aversion and news sensitivity. The state-dependent sensitivity to news creates the type of volatility clustering found in low-frequency stock returns. We find empirical support for our model's predictions that relate the scorecard to conditional volatility and skewness.


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