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Abstract

This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they generate forecasts of the conditional variance of a stock's return. Recursive updating of the conditional variance and expected return implies two mechanisms through which learning impacts stock prices: occasional shocks may lead agents to lower their risk estimate and increase their expected return, thereby triggering a bubble; along a bubble path recursive estimates of risk will increase and crash the bubble.

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File URL: http://economics.uoregon.edu/papers/UO-2008-1_Evans_Crash.pdf
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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 2008-1.

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Handle: RePEc:ore:uoecwp:2008-1

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Postal: 1285 University of Oregon, 435 PLC, Eugene, OR 97403-1285
Phone: (541) 346-4661
Fax: (541) 346-1243
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Web page: http://economics.uoregon.edu/
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Related research

Keywords: Risk; asset pricing; bubbles; adaptive learning.;

Other versions of this item:

Find related papers by JEL classification:

• G12 - Financial Economics - - General Financial Markets - - - Asset Pricing
• G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies
• D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
• D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search, Learning, and Information

This paper has been announced in the following NEP Reports:

• NEP-ALL-2008-02-23 (All new papers)

References

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Citations

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Cited by:

1. Fabio Milani, 2008. "Learning about the Interdependence between the Macroeconomy and the Stock Market," Working Papers 070819, University of California-Irvine, Department of Economics.
2. 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.
   
   • George W. Evans & Avik Chakraborty, 2006. "Can Perpetual Learning Explain the Forward Premium Puzzle?," University of Oregon Economics Department Working Papers 2006-8, University of Oregon Economics Department, revised 20 Aug 2006.
3. Sudipto Bhattacharya & Charles Goodhart & Dimitrios Tsomocos & Alexandros Vardoulakis, 2011. "Minsky’s Financial Instability Hypothesis and the Leverage Cycle," FMG Special Papers sp202, Financial Markets Group.
4. George W. Evans, 2011. "Comment on "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing"," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 61-71 National Bureau of Economic Research, Inc.
5. Lof, Matthijs, 2012. "Rational Speculators, Contrarians and Excess Volatility," MPRA Paper 43490, University Library of Munich, Germany.
6. David G. Mayes, 2008. "Avoiding the Next Crisis," CESifo Forum, Ifo Institute for Economic Research at the University of Munich, vol. 9(4), pages 44-50, December.
7. 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.
8. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.

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