Do Subjective Expectations Explain Asset Pricing Puzzles?

37 Pages Posted: 14 Apr 2010

See all articles by Gurdip Bakshi

Gurdip Bakshi

Temple University-Fox School of Business

Georgios Skoulakis

University of Piraeus - Department of Banking and Financial Management

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Date Written: November 30, 2009

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 the predictive distribution 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.

Suggested Citation

Bakshi, Gurdip S. and Skoulakis, Georgios, Do Subjective Expectations Explain Asset Pricing Puzzles? (November 30, 2009). Journal of Financial Economics (JFE), 2010, Available at SSRN: https://ssrn.com/abstract=1587784

Gurdip S. Bakshi (Contact Author)

Temple University-Fox School of Business ( email )

PA 19122
United States

Georgios Skoulakis

University of Piraeus - Department of Banking and Financial Management ( email )

80 Karaoli & Dimitriou Str.
18534 Piraeus, 185 34 -GR
Greece

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