Asset Pricing in Production Economies with Extrapolative Expectations

48 Pages Posted: 21 Mar 2011 Last revised: 25 Sep 2015

See all articles by David A. Hirshleifer

David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business; NBER

Jun Li

University of Texas at Dallas

Jianfeng Yu

Tsinghua University - PBC School of Finance

Date Written: July 2015

Abstract

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

Hirshleifer, David A. and Li, Jun and Yu, Jianfeng, Asset Pricing in Production Economies with Extrapolative Expectations (July 2015). Journal of Monetary Economics, Forthcoming; AFA 2012 Chicago Meetings Paper. Available at SSRN: https://ssrn.com/abstract=1785961 or http://dx.doi.org/10.2139/ssrn.1785961

David A. Hirshleifer

University of California, Irvine - Paul Merage School of Business ( email )

Irvine, CA California 92697-3125
United States

HOME PAGE: http://sites.uci.edu/dhirshle/

NBER ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Jun Li

University of Texas at Dallas ( email )

800 West Campbell Road, SM 31
Richardson, TX 75080
United States
972-883-4422 (Phone)

Jianfeng Yu (Contact Author)

Tsinghua University - PBC School of Finance ( email )

No. 43, Chengdu Road
Haidian District
Beijing 100083
China

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