Asset pricing in production economies with extrapolative expectations

David Hirshleifer, Jun Li and Jianfeng Yu

Journal of Monetary Economics, 2015, vol. 76, issue C, 87-106

Abstract: Introducing extrapolative bias into a standard production-based model with recursive preferences reconciles salient stylized facts about business cycles (low consumption volatility, high investment volatility relative to output) and financial markets (high equity premium, volatile stock returns, low and smooth risk-free rate) with plausible levels of risk aversion and intertemporal elasticity of substitution. Furthermore, the model captures return predictability based upon dividend yield, Q, and investment. Intuitively, extrapolative bias increases the variation in the wealth–consumption ratio, which is heavily priced under recursive preferences; adjustment costs decrease the covariance between marginal utility and asset returns. Empirical support for key implications of the model is also provided.

Keywords: Extrapolation; Production-based model; Long-run risk; Recursive preferences (search for similar items in EconPapers)
Date: 2015
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Citations: View citations in EconPapers (72)

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Persistent link: https://EconPapers.repec.org/RePEc:eee:moneco:v:76:y:2015:i:c:p:87-106

DOI: 10.1016/j.jmoneco.2015.08.006

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