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Asset Pricing under Rational Learning about Rare Disasters

  • Volker Wieland

    (Goethe University Frankfurt)

  • Christos Koulovatianos

    (University of Nottingham)

This paper proposes a new approach for modeling investor fear after rare disasters. The key element is to take into account that investors' information about fundamentals driving rare downward jumps in the dividend process is not perfect. Bayesian learning implies that beliefs about the likelihood of rare disasters drop to a much more pessimistic level once a disaster has occurred. Such a shift in beliefs can trigger massive declines in price-dividend ratios. Pessimistic beliefs persist for some time. Thus, belief dynamics are a source of apparent excess volatility relative to a rational expectations benchmark. Due to the low frequency of disasters, even an infinitely-lived investor will remain uncertain about the exact probability. Our analysis is conducted in continuous time and offers closed-form solutions for asset prices. We distinguish between rational and adaptive Bayesian learning. Rational learners account for the possibility of future changes in beliefs in determining their demand for risky assets, while adaptive learners take beliefs as given. Thus, risky assets tend to be lower-valued and price-dividend ratios vary less under adaptive versus rational learning for identical priors.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1417.

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Date of creation: 2011
Date of revision:
Handle: RePEc:red:sed011:1417
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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