Realized Expectations and the Equilibrium Risk-Return Trade Off

Abstract:     
Intuition, finance theory and up-to-date leading asset pricing models appear at odds with the empirical evidence that expected returns are weakly or negatively related to volatility at the market level. This paper investigates this issue through a simple, closed form and parsimonious continuous-time general equilibrium model, which, as a novelty, provides a connection among the investors' realized expectations of fundamentals and of market returns, as documented by survey data. Forecasts about economic growth suggest a lack of long-run reversion which leads to the alternation of waives of optimism and pessimism and produces a feedback effect which renders the dynamics of aggregate risk perceived by the investors both more volatile and more persistent. Such a mechanism provides at equilibrium a rationale for the weak or negative risk-return relation and its dynamics, in line with the investors' realized expectations of market returns. The model emphasizes the importance of aggregate beliefs in the understanding of financial markets and is robust to many of their features: indeed, it helps to explain the levels of the equity premium and of the risk-free rate, the smooth dynamics of the latter, the persistence of the dividend yield, the predictability and countercyclical dynamics of excess returns and upward-sloping real yields with decreasing volatilities.

An earlier version of this paper was circulated under the title "Asset Prices and the Joint Formation of Habit and Beliefs."

Number of Pages in PDF File: 66

Keywords: general equilibrium, negative risk-return trade off, realized expectations, asset pricing puzzles, heterogeneous preferences, external habit, forecast errors, closed-form expression

JEL Classification: D51, D53, D83, G11, G12

working papers series