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American Economic Review: Vol. 90 No. 4 (September 2000)

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Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?

Article Citation

Cecchetti, Stephen G., Pok-sang Lam, and Nelson C. Mark. 2000. "Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?" American Economic Review, 90(4): 787-805.

DOI: 10.1257/aer.90.4.787

Abstract

We study a Lucas asset-pricing model that is standard in all respects, except that the representative agent's subjective beliefs about endowment growth are distorted. Using constant relative risk-aversion (CRRA) utility, with a CRRA coefficient below 10; fluctuating beliefs that exhibit, on average, excessive pessimism over expansions; and excessive optimism over contractions (both ending more quickly than the data suggest), our model is able to match the first and second moments of the equity premium and risk-free rate, as well as he persistence and predictability of excess returns found in the data.

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Authors

Cecchetti, Stephen G. (OH State U)
Lam, Pok-sang (OH State U)
Mark, Nelson C. (OH State U)

JEL Classifications

G12: Asset Pricing; Trading volume; Bond Interest Rates
E44: Financial Markets and the Macroeconomy


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