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

  • William A. Branch
  • George W. Evans

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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File URL: http://www.st-andrews.ac.uk/economics/CDMA/papers/wp1010.pdf
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Paper provided by Centre for Dynamic Macroeconomic Analysis in its series CDMA Working Paper Series with number 201010.

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Date of revision: 15 Apr 2010
Handle: RePEc:san:cdmawp:1010
Contact details of provider: Postal: School of Economics and Finance, University of St. Andrews, Fife KY16 9AL
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  9. Harrison Hong & Jose Scheinkman & Wei Xiong, 2005. "Asset Float and Speculative Bubbles," Levine's Bibliography 122247000000000861, UCLA Department of Economics.
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  18. Cho, In-Koo & Williams, Noah & Sargent, Thomas J, 2002. "Escaping Nash Inflation," Review of Economic Studies, Wiley Blackwell, vol. 69(1), pages 1-40, January.
  19. Blanchard, Olivier Jean, 1979. "Speculative bubbles, crashes and rational expectations," Economics Letters, Elsevier, vol. 3(4), pages 387-389.
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