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

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  • William A. Branch
  • George W. Evans

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 need to make forecasts of the conditional variance of a stock¡¯s return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents¡¯ estimates of risk.

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File URL: http://www.st-andrews.ac.uk/economics/CDMA/papers/wp1010.pdf
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Bibliographic Info

Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number 201010.

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Date of revision: 15 Apr 2010
Handle: RePEc:san:cdmawp:1010

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Keywords: Risk; Asset Pricing; Bubbles; Adaptive Learning.;

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References

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Citations

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Cited by:
  1. Cars Hommes, 2013. "Behaviorally Rational Expectations and Almost Self-Ful lling Equilibria," Tinbergen Institute Discussion Papers 13-204/II, Tinbergen Institute.
  2. Lof, Matthijs, 2012. "Rational Speculators, Contrarians and Excess Volatility," MPRA Paper 43490, University Library of Munich, Germany.
  3. 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.
  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. 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. Zhu, Xiaoneng, 2013. "Perpetual learning and stock return predictability," Economics Letters, Elsevier, vol. 121(1), pages 19-22.
  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.
  9. 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).
  10. John C. Driscoll & Steinar Holden, 2014. "Behavioral Economics and Macroeconomic Models," CESifo Working Paper Series 4785, CESifo Group Munich.
  11. 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.
  12. William A. Branch & George W. Evans, 2013. "Bubbles, Crashes and Risk," CDMA Working Paper Series 201306, Centre for Dynamic Macroeconomic Analysis.
  13. Uribe Gil, Jorge Mario, 2013. "Testing for multiple bubbles with daily data," DOCUMENTOS DE TRABAJO-CIDSE 011028, UNIVERSIDAD DEL VALLE - CIDSE.
  14. 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.
  15. Pei Kuang, 2013. "Imperfect Knowledge About Asset Prices and Credit Cycles," Discussion Papers 13-02r, Department of Economics, University of Birmingham.
  16. Ortiz, Marco, 2013. "Learning Through the Yield Curve," Working Papers 2013-018, Banco Central de Reserva del Perú.

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