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Determinants of stock market volatility and risk premia

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  • Mordecai Kurz

    ()

  • Hehui Jin
  • Maurizio Motolese

Abstract

We show the dynamics of diverse beliefs is the primary propagation mechanism of volatility in asset markets. Hence, we treat the characteristics of the market beliefs as a primary, primitive, explanation of market volatility. We study an economy with stock and riskless bond markets and formulate a financial equilibrium model with diverse and time varying beliefs. Agents’ states of belief play a key role in the market, requiring an endogenous expansion of the state space. To forecast prices agents must forecast market states of belief which are beliefs of ‘‘others’’ hence our equilibrium embodies the Keynes ‘‘Beauty Contest.’’ A ‘‘market state of belief’’ is a vector which uniquely identifies the distribution of conditional probabilities of agents. Restricting beliefs to satisfy the rationality principle of Rational Belief (see Kurz, 1994, 1997) our economy replicates well the empirical record of the (i) moments of the price/dividend ratio, risky stock return, riskless interest rate and the equity premium; (ii) Sharpe ratio and the correlation between risky returns and consumption growth; (iii) predictability of stock returns and price/dividend ratio as expressed by: (I) Variance Ratio statistic for long lags, (II) autocorrelation of these variables, and (III) mean reversion of the risky returns and the predictive power of the price/dividend ratio. Also, our model explains the presence of stochastic volatility in asset prices and returns. Two properties of beliefs drive market volatility: (i) rationalizable over confidence implying belief densities with fat tails, and (ii) rationalizable asymmetry in frequencies of bull or bear states. Copyright Springer-Verlag Berlin Heidelberg 2005

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Bibliographic Info

Article provided by Springer in its journal Annals of Finance.

Volume (Year): 1 (2005)
Issue (Month): 2 (07)
Pages: 109-147

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Handle: RePEc:kap:annfin:v:1:y:2005:i:2:p:109-147

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Web page: http://www.springerlink.com/link.asp?id=112370

Related research

Keywords: Market states of beliefs; Market volatility; Equity risk premium; Riskless rate; Over confidence; Heterogenous beliefs; Rational belief; Optimism; Pessimism; Empirical distribution; G1; G12; E43; E44; D58; D84;

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References

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Citations

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Cited by:
  1. Tim W. Cogley & Thomas J. Sargent, 2005. "The Market Price of Risk and the Equity Premium," Working Papers 522, University of California, Davis, Department of Economics.
  2. Guidolin, Massimo & Timmermann, Allan, 2007. "Properties of equilibrium asset prices under alternative learning schemes," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 31(1), pages 161-217, January.
  3. Mordecai Kurz, 2011. "Symposium: on the role of market belief in economic dynamics, an introduction," Economic Theory, Springer, Springer, vol. 47(2), pages 189-204, June.
  4. A. A. Brown & L. C. G. Rogers, 2009. "Heterogeneous Beliefs with Finite-Lived Agents," Papers 0907.4953, arXiv.org.
  5. Angus A Brown & L C G Rogers, 2010. "Diverse Beliefs," Papers 1001.1450, arXiv.org.
  6. Kurz, Mordecai & Jin, Hehui & Motolese, Maurizio, 2005. "The role of expectations in economic fluctuations and the efficacy of monetary policy," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 29(11), pages 2017-2065, November.
  7. Mordecai Kurz, 2007. "Rational Diverse Beliefs and Economic Volatility," Discussion Papers, Stanford Institute for Economic Policy Research 06-045, Stanford Institute for Economic Policy Research.
  8. Kurz, Mordecai, 2006. "Beauty contests under private information and diverse beliefs: how different?," MPRA Paper 233, University Library of Munich, Germany, revised Apr 2006.
  9. Massimo Guidolin, 2006. "High equity premia and crash fears - Rational foundations," Economic Theory, Springer, Springer, vol. 28(3), pages 693-708, 08.
  10. A. A. Brown, 2009. "Heterogeneous Beliefs with Partial Observations," Papers 0907.4950, arXiv.org.
  11. Tadeusz Kowalski & Yochanan Shachmurove, 2011. "John Maynard Keynes: Is That you Knocking on the Door?," Working Papers 56, Department of Applied Econometrics, Warsaw School of Economics.
  12. Eric Aldrich, 2012. "Trading Volume in General Equilibrium with Complete Markets," 2012 Meeting Papers, Society for Economic Dynamics 36, Society for Economic Dynamics.
  13. Tadeusz Kowalski & Yochanan Shachmurove, 2011. "An Historical Walk Through Recent Financial Crises," PIER Working Paper Archive 11-019, Penn Institute for Economic Research, Department of Economics, University of Pennsylvania.
  14. Mordecai Kurz & Maurizio Motolese, 2007. "Diverse Beliefs and Time Variability of Risk Premia," Discussion Papers, Stanford Institute for Economic Policy Research 06-044, Stanford Institute for Economic Policy Research.
  15. Kurz, Mordecai, 2008. "Beauty contests under private information and diverse beliefs: How different?," Journal of Mathematical Economics, Elsevier, vol. 44(7-8), pages 762-784, July.
  16. Kurz, Mordecai & Motolese, Maurizio, 2006. "Risk Premia, diverse belief and beauty contests," MPRA Paper 247, University Library of Munich, Germany.

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