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Endogenous Uncertainty: A Unified View of Market Volatility

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  • Mordecai Kurz

Abstract

September 9, 1997 (Updated November 28, 1998) The theory of Rational Belief Equilibria (RBE) offers a unified paradigm for explaining market volatility by the effect of "Endogenous Uncertainty" on financial markets. This uncertainty is propagated within the economy (hence "endogenous") by the beliefs of asset traders. The theory of RBE was developed in a sequence of papers assembled in a recently published book (Kurz [1997]) and the present paper provides a non-mathematical exposition of both the main ideas of the theory of RBE as well as a summary of the main results of the book regarding market volatility. Section I starts by reviewing the standard assumptions underlying models of Rational Expectations Equilibria (REE) and their implications to market volatility. The paper then reviews four basic problems which have constituted puzzles or anomalies in relation to the assumptions of REE : (i) Why are asset prices much more volatile than their underlying fundamentals? (ii) The equity premium puzzle: why under REE the predicted riskless rate is so high and the equity risk premium so low? (iii) Why do asset prices exhibit the "GARCH" behavior without exogenous fundamental variables to explain it? (iv) the "Forward Discount Bias" in foreign exchange: why are interest rate differentials poor predictors of future changes in the exchange rates? Section II outlines the basic assumptions of the theory of RBE and the main propositions which it implies for market volatility. Section III develops the simulation models which are used to study the four problems above and explains that the domestic economy is calibrated, as in Mehra and Prescott [1985], to the U.S. economy. Then for each of the four problems the relevant simulation results of the RBE are presented and compared to the results predicted by a corresponding REE and to the actual empirical observations in the U.S. The paper concludes that the main cause of market volatility is t
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Suggested Citation

  • Mordecai Kurz, "undated". "Endogenous Uncertainty: A Unified View of Market Volatility," Working Papers 97027, Stanford University, Department of Economics.
    • Handle: RePEc:wop:stanec:97027
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    1. Mehra, Rajnish & Prescott, Edward C., 1985. "The equity premium: A puzzle," Journal of Monetary Economics, Elsevier, vol. 15(2), pages 145-161, March.
    2. Brock, William A & LeBaron, Blake D, 1996. "A Dynamic Structural Model for Stock Return Volatility and Trading Volume," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 94-110, February.
    3. Weil, Philippe, 1989. "The equity premium puzzle and the risk-free rate puzzle," Journal of Monetary Economics, Elsevier, vol. 24(3), pages 401-421, November.
    4. Epstein, Larry G. & Zin, Stanley E., 1990. "'First-order' risk aversion and the equity premium puzzle," Journal of Monetary Economics, Elsevier, vol. 26(3), pages 387-407, December.
    5. Willaiam A. Brock, 1996. "Asset Price Behavior in Complex Environments," Working Papers 96-04-018, Santa Fe Institute.
    6. Bollerslev, Tim & Engle, Robert F. & Nelson, Daniel B., 1986. "Arch models," Handbook of Econometrics, in: R. F. Engle & D. McFadden (ed.), Handbook of Econometrics, edition 1, volume 4, chapter 49, pages 2959-3038, Elsevier.
    7. John Y. Campbell & John Cochrane, 1999. "Force of Habit: A Consumption-Based Explanation of Aggregate Stock Market Behavior," Journal of Political Economy, University of Chicago Press, vol. 107(2), pages 205-251, April.
    8. Kenneth A. Froot, 1990. "Short Rates and Expected Asset Returns," NBER Working Papers 3247, National Bureau of Economic Research, Inc.
    9. Mankiw, N. Gregory, 1986. "The equity premium and the concentration of aggregate shocks," Journal of Financial Economics, Elsevier, vol. 17(1), pages 211-219, September.
    10. Steven N. Durlauf, 1993. "Nonergodic Economic Growth," Review of Economic Studies, Oxford University Press, vol. 60(2), pages 349-366.
    11. Froot, Kenneth A & Thaler, Richard H, 1990. "Foreign Exchange," Journal of Economic Perspectives, American Economic Association, vol. 4(3), pages 179-192, Summer.
    12. Kurz, Mordecai, 1994. "On Rational Belief Equilibria," Economic Theory, Springer;Society for the Advancement of Economic Theory (SAET), vol. 4(6), pages 859-876, October.
    13. Engel, Charles, 1996. "The forward discount anomaly and the risk premium: A survey of recent evidence," Journal of Empirical Finance, Elsevier, vol. 3(2), pages 123-192, June.
    14. Follmer, Hans, 1974. "Random economies with many interacting agents," Journal of Mathematical Economics, Elsevier, vol. 1(1), pages 51-62, March.
    15. Constantinides, George M, 1990. "Habit Formation: A Resolution of the Equity Premium Puzzle," Journal of Political Economy, University of Chicago Press, vol. 98(3), pages 519-543, June.
    16. repec:hal:spmain:info:hdl:2441/8686 is not listed on IDEAS
    17. Mordecai Kurz, 1997. "Social States of Belief and the Determinants of the Equity Risk Premium in A Rational Belief Equilibrium," Working Papers 97026, Stanford University, Department of Economics.
    18. William A. Brock, 1993. "Pathways to randomness in the economy: Emergent nonlinearity and chaos in economics and finance," Estudios Económicos, El Colegio de México, Centro de Estudios Económicos, vol. 8(1), pages 3-55.
    19. Bollerslev, Tim & Chou, Ray Y. & Kroner, Kenneth F., 1992. "ARCH modeling in finance : A review of the theory and empirical evidence," Journal of Econometrics, Elsevier, vol. 52(1-2), pages 5-59.
    20. Brock, W.A., 1996. "Asset Price Behavior in Complex Environments," Working papers 9606, Wisconsin Madison - Social Systems.
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    1. Siddiqi, Hammad, 2007. "Rational Interacting Agents and Volatility Clustering: A New Approach," MPRA Paper 2984, University Library of Munich, Germany.
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    More about this item

    JEL classification:

    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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