Do Subjective Expectations Explain Asset Pricing Puzzles?

Abstract

The structural uncertainty model with Bayesian learning, advanced by Weitzman (AER 2007), provides a framework for gauging the effect of structural uncertainty on asset prices and risk premiums. This paper provides an operational version of this approach that incorporates realistic priors about consumption growth volatility, while guaranteeing finite asset pricing quantities. In contrast to the extant literature, the resulting asset pricing model with subjective expectations yields well-defined expected utility, finite moment generating function of consumption growth, and tractable expressions for equity premium and riskfree return. Our quantitative analysis reveals that explaining the historical equity premium and riskfree return, in the context of subjective expectations, requires implausible levels of structural uncertainty. Furthermore, these implausible prior beliefs result in consumption disaster probabilities that virtually coincide with those implied by more realistic priors. At the same time, the two sets of prior beliefs have diametrically opposite asset pricing implications: one asserting, and the other contradicting, the antipuzzle view.

Keywords: subjective expectations; learning; structural uncertainty; priors; predictive density of consumption growth; equity premium; riskfree return

JEL Classification: D34, G12