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American Economic Journal: Macroeconomics: Vol. 3 No. 3 (July 2011)

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

Article Citation

Branch, William A., and George W. Evans. 2011. "Learning about Risk and Return: A Simple Model of Bubbles and Crashes." American Economic Journal: Macroeconomics, 3(3): 159-91.

DOI: 10.1257/mac.3.3.159

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)

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Authors

Branch, William A. (U CA, Irvine)
Evans, George W. (U OR and U St Andrews)

JEL Classifications

D81: Criteria for Decision-Making under Risk and Uncertainty
D83: Search; Learning; Information and Knowledge; Communication; Belief
E32: Business Fluctuations; Cycles
G01: Financial Crises
G12: Asset Pricing; Trading volume; Bond Interest Rates

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American Economic Journal: Macroeconomics


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