Asset Pricing in Production Economies with Extrapolative Expectations
48 Pages Posted: 21 Mar 2011 Last revised: 25 Sep 2015
Date Written: July 2015
Introducing extrapolative bias into a standard production-based model with recursive preferences reconciles salient stylized facts about business cycles (low consumption volatility, high investment volatility relative to output) and financial markets (high equity premium, volatile stock returns, low and smooth riskfree rate) with plausible levels of risk aversion and intertemporal elasticity of substitution. Furthermore, the model captures return predictability based upon dividend yield, Q, and investment. Intuitively, extrapolative bias increases the variation in the wealth-consumption ratio, which is heavily priced under recursive preferences; adjustment costs decrease the covariance between marginal utility and asset returns. We provide empirical support for key implications of the model.
Keywords: Extrapolation, long-run risk, production-based model, recursive preferences
JEL Classification: G02, G12, G14, E30
Suggested Citation: Suggested Citation