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

  • Wiliam Branch

    (University of Californis - Irvine)

  • George W. Evans

    ()

    (University of Oregon Economics Department)

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 generate forecasts of the conditional variance of a stock's return. Recursive updating of the conditional variance and expected return implies two mechanisms through which learning impacts stock prices: occasional shocks may lead agents to lower their risk estimate and increase their expected return, thereby triggering a bubble; along a bubble path recursive estimates of risk will increase and crash the bubble.

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Paper provided by University of Oregon Economics Department in its series University of Oregon Economics Department Working Papers with number 2008-1.

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Handle: RePEc:ore:uoecwp:2008-1
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