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

William A Branch, George W Evans

    Research output: Contribution to journalArticlepeer-review

    Abstract

    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. (JEL D81, D83, E32, G01, G12)
    Original languageEnglish
    Pages (from-to)159-191
    Number of pages33
    JournalAmerican Economic Journal: Macroeconomics
    Volume3
    Issue number3
    DOIs
    Publication statusPublished - Jul 2011

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