Regime Shifts and Changing Volatility in Stock Returns: A Rational Expectations Equilibrium Model
Center for Research in Security Prices Working Paper No. 474
49 Pages Posted: 11 Sep 1998
Date Written: May 1998
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.
JEL Classification: G12, G13, G14
Suggested Citation: Suggested Citation