Regime Shifts and Changing Volatility in Stock Returns: A Rational Expectations Equilibrium Model
University of Chicago - Booth School of Business; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)
Center for Research in Security Prices Working Paper No. 474
I present an intertemporal asset pricing model of learning to explain the GARCH behavior of stock returns and the intertemporal variation of expected returns. I assume that dividends follow a diffusion process whose drift rate shifts between two unobservable states at random times. I first show that the asset price is increasing and convex in investors' posterior probability of the good state. I then characterize the changes in asset price sensitivity to news, return volatility and expected returns as function of investors' level of uncertainty over the state of the economy.
Number of Pages in PDF File: 49
JEL Classification: G12, G13, G14
Date posted: September 11, 1998
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