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

William A. Branch () and George William Evans ()

University of Oregon Economics Department Working Papers from University of Oregon Economics Department

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 generate forecasts of the conditional variance of a stock's return. Recursive updating of the conditional variance and expected return implies two mechanisms through which learning impacts stock prices: occasional shocks may lead agents to lower their risk estimate and increase their expected return, thereby triggering a bubble; along a bubble path recursive estimates of risk will increase and crash the bubble.

Keywords: Risk; asset pricing; bubbles; adaptive learning. (search for similar items in EconPapers)
JEL-codes: G12 G14 D82 D83 (search for similar items in EconPapers)
Date: Written
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Persistent link: http://EconPapers.repec.org/RePEc:ore:uoecwp:2008-1

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