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

  • Branch, William A.
  • Evans, George W.

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://repo.sire.ac.uk/handle/10943/165
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Paper provided by Scottish Institute for Research in Economics (SIRE) in its series SIRE Discussion Papers with number 2010-33.

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Date of creation: 2010
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Handle: RePEc:edn:sirdps:165
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