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Learning about Risk and Return: A Simple Model of Bubbles and Crashes

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  • William A. Branch
  • George W. Evans

Abstract

This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they need to make forecasts of the conditional variance of a stock's return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles, and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents' estimates of risk. (JEL D81, D83, E32, G01, G12)

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Bibliographic Info

Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 3 (2011)
Issue (Month): 3 (July)
Pages: 159-91

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Handle: RePEc:aea:aejmac:v:3:y:2011:i:3:p:159-91

Note: DOI: 10.1257/mac.3.3.159
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References

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Citations

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Cited by:
  1. Zhu, Xiaoneng, 2013. "Perpetual learning and stock return predictability," Economics Letters, Elsevier, vol. 121(1), pages 19-22.
  2. Cars Hommes, 2013. "Behaviorally Rational Expectations and Almost Self-Ful lling Equilibria," Tinbergen Institute Discussion Papers 13-204/II, Tinbergen Institute.
  3. Hommes, Cars H., 2014. "Behaviorally Rational Expectations and Almost Self-Fulfilling Equilibria," Review of Behavioral Economics, now publishers, vol. 1(1-2), pages 75-97, January.
  4. LeBaron, Blake, 2012. "Heterogeneous gain learning and the dynamics of asset prices," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 424-445.
  5. Ortiz, Marco, 2013. "Learning Through the Yield Curve," Working Papers 2013-018, Banco Central de Reserva del Perú.
  6. George W. Evans, 2011. "Comment on "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing"," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 61-71 National Bureau of Economic Research, Inc.
  7. William A. Branch & George W. Evans, 2013. "Bubbles, Crashes and Risk," CDMA Working Paper Series 201306, Centre for Dynamic Macroeconomic Analysis.
  8. Aitken, Michael & Cumming, Douglas & Zhan, Feng, 2013. "High frequency trading and end-of-day price dislocation," CFS Working Paper Series 2013/16, Center for Financial Studies (CFS).
  9. Airaudo, Marco & Cardani, Roberta & Lansing, Kevin J., 2013. "Monetary policy and asset prices with belief-driven fluctuations," Journal of Economic Dynamics and Control, Elsevier, vol. 37(8), pages 1453-1478.
  10. Uribe Gil, Jorge Mario, 2013. "Testing for multiple bubbles with daily data," DOCUMENTOS DE TRABAJO-CIDSE 011028, UNIVERSIDAD DEL VALLE - CIDSE.
  11. Hommes, Cars & Zhu, Mei, 2014. "Behavioral learning equilibria," Journal of Economic Theory, Elsevier, vol. 150(C), pages 778-814.
  12. Pei Kuang, 2013. "Imperfect Knowledge About Asset Prices and Credit Cycles," Discussion Papers 13-02r, Department of Economics, University of Birmingham.
  13. Sudipto Bhattacharya & Charles Goodhart & Dimitrios Tsomocos & Alexandros Vardoulakis, 2011. "Minsky’s Financial Instability Hypothesis and the Leverage Cycle," FMG Special Papers sp202, Financial Markets Group.
  14. Giusto, Andrea, 2014. "Adaptive learning and distributional dynamics in an incomplete markets model," Journal of Economic Dynamics and Control, Elsevier, vol. 40(C), pages 317-333.
  15. Lof, Matthijs, 2012. "Rational Speculators, Contrarians and Excess Volatility," MPRA Paper 43490, University Library of Munich, Germany.
  16. Driscoll, John C. & Holden, Steinar, 2014. "Behavioral Economics and Macroeconomic Models," Finance and Economics Discussion Series 2014-43, Board of Governors of the Federal Reserve System (U.S.).
  17. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.

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