Asset Pricing with Return Extrapolation

Abstract

We present a new model of asset prices in which the agent has Epstein-Zin preferences and extrapolative beliefs about stock market returns. Unlike earlier return extrapolation models, our model allows for a quantitative comparison with the data on asset prices and expectations. The model generates excess volatility and predictability of stock market returns, a high equity premium, a low and stable risk-free rate, a persistent price-dividend ratio, and a low correlation between stock market returns and consumption growth. Moreover, the agent's expectations about future returns depend positively on recent past returns, consistent with survey evidence on return expectations.

Keywords: Expectations, Return Extrapolation, Stock Market Movements

JEL Classification: G02, G12