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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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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
Date of revision:
Handle: RePEc:edn:sirdps:165
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  1. Bruce McGough, 2003. "Shocking Escapes," Computing in Economics and Finance 2003 294, Society for Computational Economics.
  2. Harrison Hong & José Scheinkman & Wei Xiong, 2006. "Asset Float and Speculative Bubbles," Journal of Finance, American Finance Association, vol. 61(3), pages 1073-1117, 06.
  3. Carceles-Poveda, Eva & Giannitsarou, Chryssi, 2007. "Asset Pricing with Adaptive Learning," CEPR Discussion Papers 6223, C.E.P.R. Discussion Papers.
  4. In-Koo Cho & Noah Williams & Thomas J. Sargent, 2002. "Escaping Nash Inflation," Review of Economic Studies, Oxford University Press, vol. 69(1), pages 1-40.
  5. Timmermann, Allan, 1994. "Can Agents Learn to Form Rational Expectations? Some Results on Convergence and Stability of Learning in the UK Stock Market," Economic Journal, Royal Economic Society, vol. 104(425), pages 777-97, July.
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  8. Jonathan Lewellen & Jay Shanken, 2002. "Learning, Asset-Pricing Tests, and Market Efficiency," Journal of Finance, American Finance Association, vol. 57(3), pages 1113-1145, 06.
  9. Branch, William A. & Evans, George W., 2006. "A simple recursive forecasting model," Economics Letters, Elsevier, vol. 91(2), pages 158-166, May.
  10. Harrison Hong & Jose Scheinkman & Wei Xiong, 2005. "Advisors and Asset Prices: A Model of the Origins of Bubbles," Levine's Bibliography 122247000000001003, UCLA Department of Economics.
  11. Allen F. & Morris S. & Postlewaite A., 1993. "Finite Bubbles with Short Sale Constraints and Asymmetric Information," Journal of Economic Theory, Elsevier, vol. 61(2), pages 206-229, December.
  12. Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2006. "Learning and Stock Market Volatility," Computing in Economics and Finance 2006 15, Society for Computational Economics.
  13. Kenneth D. West, 1986. "A Specification Test for Speculative Bubbles," NBER Working Papers 2067, National Bureau of Economic Research, Inc.
  14. Geweke, John, 2001. "A note on some limitations of CRRA utility," Economics Letters, Elsevier, vol. 71(3), pages 341-345, June.
  15. Marcet, Albert & Sargent, Thomas J., 1989. "Convergence of least squares learning mechanisms in self-referential linear stochastic models," Journal of Economic Theory, Elsevier, vol. 48(2), pages 337-368, August.
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  17. Manuel S. Santos & Michael Woodford, 1993. "Rational Asset Pricing Bubbles," Working Papers 9304, Centro de Investigacion Economica, ITAM.
  18. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
  19. Thomas Sargent & Noah Williams & Tao Zha, 2009. "The Conquest of South American Inflation," Journal of Political Economy, University of Chicago Press, vol. 117(2), pages 211-256, 04.
  20. Kenneth A. Froot & Maurice Obstfeld, 1989. "Intrinsic Bubbles: The Case of Stock Prices," NBER Working Papers 3091, National Bureau of Economic Research, Inc.
  21. Merton, Robert C., 1980. "On estimating the expected return on the market : An exploratory investigation," Journal of Financial Economics, Elsevier, vol. 8(4), pages 323-361, December.
  22. repec:bla:restud:v:65:y:1998:i:1:p:23-44 is not listed on IDEAS
  23. Martin L. Weitzman, 2007. "Subjective Expectations and Asset-Return Puzzles," American Economic Review, American Economic Association, vol. 97(4), pages 1102-1130, September.
  24. George W. Evans & Seppo Honkapohja, . "Economic Dynamics with Learning: New Stability Results," Computing in Economics and Finance 1997 51, Society for Computational Economics.
  25. Jean-Michel Grandmont, 1997. "Expectations Formation and Stability of Large Socioeconomic Systems," Working Papers 97-27, Centre de Recherche en Economie et Statistique.
  26. Cho, In-Koo & Kasa, Kenneth, 2008. "Learning Dynamics And Endogenous Currency Crises," Macroeconomic Dynamics, Cambridge University Press, vol. 12(02), pages 257-285, April.
  27. Eli Ofek & Matthew Richardson, 2003. "DotCom Mania: The Rise and Fall of Internet Stock Prices," Journal of Finance, American Finance Association, vol. 58(3), pages 1113-1138, 06.
  28. Evans, George W, 1991. "Pitfalls in Testing for Explosive Bubbles in Asset Prices," American Economic Review, American Economic Association, vol. 81(4), pages 922-30, September.
  29. Eva Carceles-Poveda & Chryssi Giannitsarou, 2007. "Online Appendix to Asset Pricing with Adaptive Learning," Technical Appendices carceles08, Review of Economic Dynamics.
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