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Asset Return Dynamics and Learning

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Author Info

  • Wiliam Branch

    (University of Californis - Irvine)

  • George W. Evans

    ()
    (University of Oregon Economics Department)

Abstract

This paper advocates a theory of expectation formation that incorporates many of the central motivations of behavioral finance theory while retaining much of the discipline of the rational expectations approach. We provide a framework in which agents, in an asset pricing model, underparameterize their forecasting model in a spirit similar to Hong, Stein, and Yu (2005) and Barberis, Shleifer, and Vishny (1998), except that the parameters of the forecasting model, and the choice of predictor, are determined jointly in equilibrium. We show that multiple equilibria can exist even if agents choose only models that maximize (risk-adjusted) expected profits. A real-time learning formulation yields endogenous switching between equilibria. We demonstrate that a real-time learning version of the model, calibrated to U.S. stock data, is capable of reproducing many of the salient empirical regularities in excess return dynamics such as under/overreaction, persistence, and volatility clustering.

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Bibliographic Info

Paper provided by University of Oregon Economics Department in its series University of Oregon Economics Department Working Papers with number 2006-14.

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Length: 40
Date of creation:
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Handle: RePEc:ore:uoecwp:2006-14

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Related research

Keywords: Asset pricing; misspecification; behavioral finance; predictability; adaptive learning;

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Cited by:
  1. Andrew Ang & Allan Timmermann, 2012. "Regime Changes and Financial Markets," Annual Review of Financial Economics, Annual Reviews, vol. 4(1), pages 313-337.
  2. William Branch & George Evans, 2011. "Monetary policy and heterogeneous expectations," Economic Theory, Springer, vol. 47(2), pages 365-393, June.
  3. Hommes, Cars & Zhu, Mei, 2014. "Behavioral learning equilibria," Journal of Economic Theory, Elsevier, vol. 150(C), pages 778-814.
  4. Guillaume Chevillon & Sophocles Mavroeidis, 2013. "Learning generates Long Memory," Post-Print hal-00661012, HAL.
  5. Agnieszka Markiewicz & Andreas Pick, 2013. "Adaptive Learning and Survey Data," CDMA Working Paper Series 201305, Centre for Dynamic Macroeconomic Analysis.
  6. 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.
  7. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.
  8. Jess Benhabib & Chetan Dave, . "Learning, Large Deviations and Rare Events," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics.
  9. Zhu, Xiaoneng, 2013. "Perpetual learning and stock return predictability," Economics Letters, Elsevier, vol. 121(1), pages 19-22.
  10. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.
  11. Cars Hommes, 2013. "Behaviorally Rational Expectations and Almost Self-Ful lling Equilibria," Tinbergen Institute Discussion Papers 13-204/II, Tinbergen Institute.
  12. Paolo Gelain & Kevin J. Lansing, 2013. "House prices, expectations, and time-varying fundamentals," Working Paper 2013/05, Norges Bank.
  13. Hommes, C.H. & Zhu, M., 2012. "Behavioral Learning Equilibria," CeNDEF Working Papers 12-09, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  14. Lof, Matthijs, 2012. "Rational Speculators, Contrarians and Excess Volatility," MPRA Paper 43490, University Library of Munich, Germany.
  15. Hommes, C.H., 2013. "Behaviorally Rational Expectations and Almost Self-Fulfilling Equilibria," CeNDEF Working Papers 13-17, Universiteit van Amsterdam, Center for Nonlinear Dynamics in Economics and Finance.
  16. Michele Berardi, 2012. "Endogenous time-varying risk aversion and asset return," Centre for Growth and Business Cycle Research Discussion Paper Series 168, Economics, The Univeristy of Manchester.

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