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

  • William A. Branch
  • George W. Evans

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. (JEL D81, D83, E32, G01, G12)

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Article provided by American Economic Association in its journal American Economic Journal: Macroeconomics.

Volume (Year): 3 (2011)
Issue (Month): 3 (July)
Pages: 159-91

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Handle: RePEc:aea:aejmac:v:3:y:2011:i:3:p:159-91
Note: DOI: 10.1257/mac.3.3.159
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