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Why Do Asset Prices Not Follow Random Walks?

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  • Günter Franke

    ()
    (Department of Economics, University of Konstanz)

  • Erik Lüders

    ()
    (Pinehill Capital and Laval University)

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    Abstract

    This paper analyzes the e¤ect of non-constant elasticity of the pricing kernel on asset return characteristics in a rational expectations model. It is shown that declining elasticity of the pricing kernel can lead to predictability of asset returns and high and persistent volatility. Also, declining elasticity helps to motivate technical analysis and to explain stock market crashes. Moreover, based on a general characterization of the pricing kernel, we propose analytical asset price processes which can be tested empirically. The numerical analysis reveals strong deviations from the geometric Brownian motion which are caused by declining elasticity of the pricing kernel.

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    File URL: http://cofe.uni-konstanz.de/Papers/dp04_05.pdf
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    Bibliographic Info

    Paper provided by Center of Finance and Econometrics, University of Konstanz in its series CoFE Discussion Paper with number 04-05.

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    Length: 53 pages
    Date of creation: 18 Aug 2004
    Date of revision:
    Handle: RePEc:knz:cofedp:0405

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    Related research

    Keywords: Pricing Kernel; Viable asset price processes; Serial correlation; Heteroskedasticity; Stock market crashes;

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    References

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    Cited by:
    1. Ang, Andrew & Liu, Jun, 2007. "Risk, return, and dividends," Journal of Financial Economics, Elsevier, vol. 85(1), pages 1-38, July.

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