Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model

Günter Franke () and Erik Lüders ()
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Günter Franke: Department of Economics, University of Konstanz
Erik Lüders: Pinehill Capital and Laval University

No 05-05, CoFE Discussion Paper from Center of Finance and Econometrics, University of Konstanz

Abstract: This paper presents a simple rational expectations model of intertemporal asset pricing. It shows that 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: Written 2005-09
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Working Paper: Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model¤ (2006)
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