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Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model

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Author Info
Günter Franke () (Department of Economics, University of Konstanz)
Erik Lüders () (Pinehill Capital and Laval University)
Abstract

This paper presents a simple rational expectations model of intertemporal asset pricing. It shows that heterogeneous risk aversion of investors is likely to generate declining aggregate relative risk aversion. This leads to predictability of asset returns and high and persistent volatility. Stock market crashes may be observed if relative risk aversion differs strongly across investors. Then aggregate relative risk aversion may sharply increase given a small impairment in fundamentals so that asset prices may strongly decline. Changes in aggregate relative risk aversion may also lead to resistance and support levels as used in technical analysis. For numerical illustration we propose an analytical asset price formula.

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

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Length: 34 pages
Date of creation: Sep 2005
Date of revision:
Handle: RePEc:knz:cofedp:0505

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Related research
Keywords: Aggregate relative risk aversion; Equilibrium asset price processes; Excess Volatility; Return predictability; Stock market crashes;

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Find related papers by JEL classification:
G12 - Financial Economics - - General Financial Markets - - - Asset Pricing

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