Return predictability and stock market crashes in a simple rational expectation models

Günter Franke and Erik Lüders

No 06/05, CoFE Discussion Papers from University of Konstanz, Center of Finance and Econometrics (CoFE)

Abstract: This paper presents a simple rational expectations model of intertemporal asset pricing. It shows that state-independent heterogeneous risk aversion of investors is likely to generate declining aggregate relative risk aversion. This leads to predictability of asset returns and high and persistent volatility. Stock market crashes may be observed if relative risk aversion differs strongly across investors. Then aggregate relative risk aversion may sharply increase given a small impairment in fundamentals so that asset prices may strongly decline. Changes in aggregate relative risk aversion may also lead to resistance and support levels as used in technical analysis. For numerical illustration we propose an analytical asset price formula.

Keywords: Aggregate relative risk aversion; Equilibrium asset price processes; Excess Volatility; Return predictability; Stock market crashes (search for similar items in EconPapers)
JEL-codes: G12 (search for similar items in EconPapers)
Date: 2006
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Citations: View citations in EconPapers (1)

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Persistent link: https://EconPapers.repec.org/RePEc:zbw:cofedp:0605

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