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Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?

  • Pok-sang Lam
  • Stephen G. Cecchetti
  • Nelson C. Mark

We study a Lucas asset-pricing model that is standard in all respects, except that the representative agent's subjective beliefs about endowment growth are distorted. Using constant relative risk-aversion (CRRA) utility, with a CRRA coefficient below 10; fluctuating beliefs that exhibit, on average, excessive pessimism over expansions; and excessive optimism over contractions (both ending more quickly than the data suggest), our model is able to match the first and second moments of the equity premium and risk-free rate, as well as he persistence and predictability of excess returns found in the data.

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File URL: http://www.aeaweb.org/articles.php?doi=10.1257/aer.90.4.787
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Article provided by American Economic Association in its journal American Economic Review.

Volume (Year): 90 (2000)
Issue (Month): 4 (September)
Pages: 787-805

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Handle: RePEc:aea:aecrev:v:90:y:2000:i:4:p:787-805
Note: DOI: 10.1257/aer.90.4.787
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  1. Kandel, Shmuel & Stambaugh, Robert F., 1991. "Asset returns and intertemporal preferences," Journal of Monetary Economics, Elsevier, vol. 27(1), pages 39-71, February.
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  19. Martin D.D. Evans, 1995. "Dividend Variability and Stock Market Swings," Working Papers 95-13, New York University, Leonard N. Stern School of Business, Department of Economics.
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