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High equity premia and crash fears - Rational foundations

  • Massimo Guidolin

    ()

We show that in a Lucas endowment economy in which the process for dividends is described by a lattice tree subject to infrequent but observable structural breaks, in equilibrium recursive rational learning may inflate the equity risk premium and reduce the risk-free interest rate for low levels of risk aversion. The key condition for these results to obtain is the presence of sufficient initial pessimism. The relevance of these findings is magnified by the fact that under full information our artificial economy cannot generate asset returns matching the empirical evidence for any positive relative risk aversion. Copyright Springer-Verlag Berlin/Heidelberg 2006

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File URL: http://hdl.handle.net/10.1007/s00199-005-0639-0
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Article provided by Springer in its journal Economic Theory.

Volume (Year): 28 (2006)
Issue (Month): 3 (08)
Pages: 693-708

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Handle: RePEc:spr:joecth:v:28:y:2006:i:3:p:693-708
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  1. Mordecai Kurz & Hehui Jin & Maurizio Motolese, 2005. "Determinants of stock market volatility and risk premia," Annals of Finance, Springer, vol. 1(2), pages 109-147, 07.
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  12. Carsten Krabbe Nielsen, 1996. "Rational belief structures and rational belief equilibria (*)," Economic Theory, Springer, vol. 8(3), pages 399-422.
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  15. Barsky, Robert B & De Long, J Bradford, 1993. "Why Does the Stock Market Fluctuate?," The Quarterly Journal of Economics, MIT Press, vol. 108(2), pages 291-311, May.
  16. Guidolin, Massimo & Timmermann, Allan, 2007. "Properties of equilibrium asset prices under alternative learning schemes," Journal of Economic Dynamics and Control, Elsevier, vol. 31(1), pages 161-217, January.
  17. Andrew B. Abel, 2001. "An exploration of the effects of pessimism and doubt on asset returns," Working Papers 01-1, Federal Reserve Bank of Philadelphia.
  18. Mehra, Rajnish & Prescott, Edward C., 1988. "The equity risk premium: A solution?," Journal of Monetary Economics, Elsevier, vol. 22(1), pages 133-136, July.
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