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Learning about Risk and Return: A Simple Model of Bubbles and Crashes

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  • Wiliam Branch

    (University of Californis - Irvine)

  • George W. Evans

    ()
    (University of Oregon Economics Department)

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

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References

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  1. Albert Marcet & Juan P. Nicolini, 1995. "Recurrent hyperinflations and learning," Economics Working Papers 244, Department of Economics and Business, Universitat Pompeu Fabra, revised Nov 2001.
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Citations

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Cited by:
  1. Pei Kuang, 2013. "Imperfect Knowledge About Asset Prices and Credit Cycles," Discussion Papers 13-02r, Department of Economics, University of Birmingham.
  2. 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.
  3. Airaudo, Marco & Cardani, Roberta & Lansing, Kevin J., 2013. "Monetary policy and asset prices with belief-driven fluctuations," Journal of Economic Dynamics and Control, Elsevier, vol. 37(8), pages 1453-1478.
  4. 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.
  5. LeBaron, Blake, 2012. "Heterogeneous gain learning and the dynamics of asset prices," Journal of Economic Behavior & Organization, Elsevier, vol. 83(3), pages 424-445.
  6. Driscoll, John C. & Holden, Steinar, 2014. "Behavioral Economics and Macroeconomic Models," Finance and Economics Discussion Series 2014-43, Board of Governors of the Federal Reserve System (U.S.).
  7. William A. Branch & George W. Evans, 2013. "Bubbles, Crashes and Risk," CDMA Working Paper Series 201306, Centre for Dynamic Macroeconomic Analysis.
  8. 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.
  9. Zhu, Xiaoneng, 2013. "Perpetual learning and stock return predictability," Economics Letters, Elsevier, vol. 121(1), pages 19-22.
  10. Aitken, Michael & Cumming, Douglas & Zhan, Feng, 2013. "High frequency trading and end-of-day price dislocation," CFS Working Paper Series 2013/16, Center for Financial Studies (CFS).
  11. Ortiz, Marco, 2013. "Learning Through the Yield Curve," Working Papers 2013-018, Banco Central de Reserva del Perú.
  12. Cars Hommes, 2013. "Behaviorally Rational Expectations and Almost Self-Ful lling Equilibria," Tinbergen Institute Discussion Papers 13-204/II, Tinbergen Institute.
  13. Uribe Gil, Jorge Mario, 2013. "Testing for multiple bubbles with daily data," DOCUMENTOS DE TRABAJO-CIDSE 011028, UNIVERSIDAD DEL VALLE - CIDSE.
  14. Lof, Matthijs, 2012. "Rational Speculators, Contrarians and Excess Volatility," MPRA Paper 43490, University Library of Munich, Germany.
  15. Giusto, Andrea, 2014. "Adaptive learning and distributional dynamics in an incomplete markets model," Journal of Economic Dynamics and Control, Elsevier, vol. 40(C), pages 317-333.
  16. Cars Hommes & Mei Zhu, 2013. "Behavioral Learning Equilibria," Tinbergen Institute Discussion Papers 13-014/II, Tinbergen Institute.
  17. 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.

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