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

William Branch () and George Evans ()

No 2010-33, SIRE Discussion Papers from Scottish Institute for Research in Economics (SIRE)

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 need to make forecasts of the conditional variance of a stock’s return. Recursive updating of both the conditional variance and the expected return implies several mechanisms through which learning impacts stock prices. Extended periods of excess volatility, bubbles and crashes arise with a frequency that depends on the extent to which past data is discounted. A central role is played by changes over time in agents’ estimates of risk.

Keywords: Risk; Asset Pricing; Bubbles; Adaptive Learning (search for similar items in EconPapers)
Date: 2010
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Journal Article: Learning about Risk and Return: A Simple Model of Bubbles and Crashes (2011) Downloads
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