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Asset Return Dynamics and Learning

Author

Listed:
  • Wiliam Branch

    (University of Californis - Irvine)

  • George W. Evans

    () (University of Oregon Economics Department)

Abstract

This paper advocates a theory of expectation formation that incorporates many of the central motivations of behavioral finance theory while retaining much of the discipline of the rational expectations approach. We provide a framework in which agents, in an asset pricing model, underparameterize their forecasting model in a spirit similar to Hong, Stein, and Yu (2005) and Barberis, Shleifer, and Vishny (1998), except that the parameters of the forecasting model, and the choice of predictor, are determined jointly in equilibrium. We show that multiple equilibria can exist even if agents choose only models that maximize (risk-adjusted) expected profits. A real-time learning formulation yields endogenous switching between equilibria. We demonstrate that a real-time learning version of the model, calibrated to U.S. stock data, is capable of reproducing many of the salient empirical regularities in excess return dynamics such as under/overreaction, persistence, and volatility clustering.

Suggested Citation

  • Wiliam Branch & George W. Evans, "undated". "Asset Return Dynamics and Learning," University of Oregon Economics Department Working Papers 2006-14, University of Oregon Economics Department.
  • Handle: RePEc:ore:uoecwp:2006-14
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    File URL: http://economics.uoregon.edu/papers/UO-2006-14_Evans_Asset.pdf
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    Keywords

    Asset pricing; misspecification; behavioral finance; predictability; adaptive learning;

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • D82 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Asymmetric and Private Information; Mechanism Design
    • D83 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Search; Learning; Information and Knowledge; Communication; Belief; Unawareness

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