Asset pricing under rational learning about rare disasters
Christos Koulovatianos and
Volker Wieland
No 46, IMFS Working Paper Series from Goethe University Frankfurt, Institute for Monetary and Financial Stability (IMFS)
Abstract:
This paper proposes a new approach for modeling investor fear after rare disasters. The key element is to take into account that investors’ information about fundamentals driving rare downward jumps in the dividend process is not perfect. Bayesian learning implies that beliefs about the likelihood of rare disasters drop to a much more pessimistic level once a disaster has occurred. Such a shift in beliefs can trigger massive declines in price-dividend ratios. Pessimistic beliefs persist for some time. Thus, belief dynamics are a source of apparent excess volatility relative to a rational expectations benchmark. Due to the low frequency of disasters, even an infinitely-lived investor will remain uncertain about the exact probability. Our analysis is conducted in continuous time and offers closed-form solutions for asset prices. We distinguish between rational and adaptive Bayesian learning. Rational learners account for the possibility of future changes in beliefs in determining their demand for risky assets, while adaptive learners take beliefs as given. Thus, risky assets tend to be lower-valued and price-dividend ratios vary less under adaptive versus rational learning for identical priors. Keywords: beliefs, Bayesian learning, controlled diffusions and jump processes, learning about jumps, adaptive learning, rational learning.
Keywords: beliefs; Bayesian learning; controlled diffusions and jump processes; learning about jumps; adaptive learning; rational learning (search for similar items in EconPapers)
JEL-codes: C11 C61 D81 D83 D91 E21 G11 (search for similar items in EconPapers)
Date: 2011
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (11)
Downloads: (external link)
https://www.econstor.eu/bitstream/10419/97775/1/IMFS_WP_46.pdf (application/pdf)
Related works:
Working Paper: Asset Pricing under Rational Learning about Rare Disasters (2011) 
Working Paper: Asset Pricing under Rational Learning about Rare Disasters (2011)
This item may be available elsewhere in EconPapers: Search for items with the same title.
Export reference: BibTeX
RIS (EndNote, ProCite, RefMan)
HTML/Text
Persistent link: https://EconPapers.repec.org/RePEc:zbw:imfswp:46
Access Statistics for this paper
More papers in IMFS Working Paper Series from Goethe University Frankfurt, Institute for Monetary and Financial Stability (IMFS) Contact information at EDIRC.
Bibliographic data for series maintained by ZBW - Leibniz Information Centre for Economics ().