Learning about Risk and Return: A Simple Model of Bubbles and Crashes
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 stockÂ¡Â¯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 agentsÂ¡Â¯ estimates of risk.
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|Date of revision:||15 Apr 2010|
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