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Endogenous Uncertainty: A Unified View of Market Volatility

Author

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  • Mordecai Kurz

Abstract

September 9, 1997 (Updated November 28, 1998) The theory of Rational Belief Equilibria (RBE) offers a unified paradigm for explaining market volatility by the effect of "Endogenous Uncertainty" on financial markets. This uncertainty is propagated within the economy (hence "endogenous") by the beliefs of asset traders. The theory of RBE was developed in a sequence of papers assembled in a recently published book (Kurz [1997]) and the present paper provides a non-mathematical exposition of both the main ideas of the theory of RBE as well as a summary of the main results of the book regarding market volatility. Section I starts by reviewing the standard assumptions underlying models of Rational Expectations Equilibria (REE) and their implications to market volatility. The paper then reviews four basic problems which have constituted puzzles or anomalies in relation to the assumptions of REE : (i) Why are asset prices much more volatile than their underlying fundamentals? (ii) The equity premium puzzle: why under REE the predicted riskless rate is so high and the equity risk premium so low? (iii) Why do asset prices exhibit the "GARCH" behavior without exogenous fundamental variables to explain it? (iv) the "Forward Discount Bias" in foreign exchange: why are interest rate differentials poor predictors of future changes in the exchange rates? Section II outlines the basic assumptions of the theory of RBE and the main propositions which it implies for market volatility. Section III develops the simulation models which are used to study the four problems above and explains that the domestic economy is calibrated, as in Mehra and Prescott [1985], to the U.S. economy. Then for each of the four problems the relevant simulation results of the RBE are presented and compared to the results predicted by a corresponding REE and to the actual empirical observations in the U.S. The paper concludes that the main cause of market volatility is t
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Suggested Citation

  • Mordecai Kurz, "undated". "Endogenous Uncertainty: A Unified View of Market Volatility," Working Papers 97027, Stanford University, Department of Economics.
    • Handle: RePEc:wop:stanec:97027
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    Cited by:

    1. Hermann Garbers, "undated". "Agents' Rationality and the CHF/USD Exchange Rate, Part I," IEW - Working Papers 163, Institute for Empirical Research in Economics - University of Zurich.
    2. Siddiqi, Hammad, 2007. "Rational Interacting Agents and Volatility Clustering: A New Approach," MPRA Paper 2984, University Library of Munich, Germany.

    More about this item

    JEL classification:

    • D58 - Microeconomics - - General Equilibrium and Disequilibrium - - - Computable and Other Applied General Equilibrium Models
    • D84 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Expectations; Speculations
    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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