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Stock Market Volatility and Learning

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  • Klaus Adam
  • Albert Marcet
  • Juan Pablo Nicolini

Abstract

We study a standard consumption based asset pricing model with rationally investing agents but allow agents' prior beliefs about price and dividend behavior to deviate slightly from rational expectations priors. Learning about stock price behavior then causes the model to become quantitatively consistent with a range of basic asset prizing 'puzzles': stock returns display momentum and mean reversion, asset prices become volatile, the price-dividend ratio displays persistence, long-horizon returns become predictable and a risk premium emerges. Comparing the moments of the model with those in the data using confidence bands from the method of simulated moments, we show that our findings are robust to different assumptions on the system of beliefs and other model features. We depart from previous studies of asset prices under learning in that agents form expectations about future stock prices using past price observations.

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Bibliographic Info

Paper provided by Centre for Economic Performance, LSE in its series CEP Discussion Papers with number dp1077.

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Date of creation: Sep 2011
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Handle: RePEc:cep:cepdps:dp1077

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Web page: http://cep.lse.ac.uk/_new/publications/series.asp?prog=CEP

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Keywords: asset pricing; learning; near-rational price forecasts;

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References

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  1. Carceles-Poveda, Eva & Giannitsarou, Chryssi, 2007. "Asset Pricing with Adaptive Learning," CEPR Discussion Papers 6223, C.E.P.R. Discussion Papers.
  2. Brock, W.A. & Hommes, C.H., 1996. "Hetergeneous Beliefs and Routes to Chaos in a Simple Asset Pricing Model," Working papers 9621, Wisconsin Madison - Social Systems.
  3. Pástor, Luboš & Veronesi, Pietro, 2002. "Stock Valuation and Learning about Profitability," CEPR Discussion Papers 3410, C.E.P.R. Discussion Papers.
  4. James Bullard & John Duffy, 1999. "Learning and Excess Volatility," Computing in Economics and Finance 1999 224, Society for Computational Economics.
  5. Albert Marcet & Juan P. Nicolini, 2003. "Recurrent Hyperinflations and Learning," American Economic Review, American Economic Association, vol. 93(5), pages 1476-1498, December.
  6. Lucas, Robert E, Jr, 1978. "Asset Prices in an Exchange Economy," Econometrica, Econometric Society, vol. 46(6), pages 1429-45, November.
  7. Adam, Klaus, 2003. "Learning and Equilibrium Selection in a Monetary Overlapping Generations Model with Sticky Prices," CFS Working Paper Series 2003/03, Center for Financial Studies (CFS).
  8. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
  9. Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2011. "Stock Market Volatility and Learning," CEP Discussion Papers dp1077, Centre for Economic Performance, LSE.
  10. John Y. Campbell & John H. Cochrane, 1994. "By Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," CRSP working papers 412, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  11. Andrew B. Abel, . "Asset Prices Under Habit Formation and Catching Up With the Jones," Rodney L. White Center for Financial Research Working Papers 1-90, Wharton School Rodney L. White Center for Financial Research.
  12. Franklin Allen & Stephen Morris & Hyun Song Shin, 2006. "Beauty Contests and Iterated Expectations in Asset Markets," Review of Financial Studies, Society for Financial Studies, vol. 19(3), pages 719-752.
  13. Stephen G. Cecchetti & Pok-sang Lam & Nelson C. Mark, 1998. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good To Be True?," NBER Working Papers 6354, National Bureau of Economic Research, Inc.
  14. Kocherlakota, Narayana R., 1990. "On the 'discount' factor in growth economies," Journal of Monetary Economics, Elsevier, vol. 25(1), pages 43-47, January.
  15. Voth, Hans-Joachim, 2002. "With a Bang, Not a Whimper: Pricking Germany's 'Stock Market Bubble' in 1927 and the Slide into Depression," CEPR Discussion Papers 3257, C.E.P.R. Discussion Papers.
  16. Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
  17. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
  18. Campbell, John Y., 2003. "Consumption-based asset pricing," Handbook of the Economics of Finance, in: G.M. Constantinides & M. Harris & R. M. Stulz (ed.), Handbook of the Economics of Finance, edition 1, volume 1, chapter 13, pages 803-887 Elsevier.
  19. Klaus Adam & Albert Marcet, 2011. "Internal Rationality, Imperfect Market Knowledge and Asset Prices," CEP Discussion Papers dp1068, Centre for Economic Performance, LSE.
  20. Mankiw, N Gregory & Romer, David & Shapiro, Matthew D, 1985. " An Unbiased Reexamination of Stock Market Volatility," Journal of Finance, American Finance Association, vol. 40(3), pages 677-87, July.
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  22. Timmermann, Allan G, 1993. "How Learning in Financial Markets Generates Excess Volatility and Predictability in Stock Prices," The Quarterly Journal of Economics, MIT Press, vol. 108(4), pages 1135-45, November.
  23. Klaus Adam, 2001. "Learning and Equilibrium Selection in a Monetary Overlapping Generations Model with Sticky," CSEF Working Papers 69, Centre for Studies in Economics and Finance (CSEF), University of Naples, Italy.
  24. Cogley, Timothy & Sargent, Thomas J., 2008. "The market price of risk and the equity premium: A legacy of the Great Depression?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 454-476, April.
  25. repec:cup:macdyn:v:5:y:2001:i:2:p:272-302 is not listed on IDEAS
  26. Brennan, Michael J. & Xia, Yihong, 2001. "Stock price volatility and equity premium," Journal of Monetary Economics, Elsevier, vol. 47(2), pages 249-283, April.
  27. Peter Bossaerts, 2004. "Filtering Returns for Unspecified Biases in Priors when Testing Asset PricingTheory," Review of Economic Studies, Wiley Blackwell, vol. 71(1), pages 63-86, 01.
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