Asset Pricing with Return Extrapolation
65 Pages Posted: 1 Oct 2017 Last revised: 15 Jul 2021
Date Written: July 14, 2021
We present a new model of asset prices in which a representative agent has extrapolative beliefs about stock market returns and Epstein-Zin preferences. The model quantitatively explains facts about asset prices, return expectations, and cash-flow expectations. When the agent's beliefs about stock market returns are calibrated to survey expectations of investors, the model generates excess volatility and predictability of stock market returns, a high equity premium, a low and stable risk-free rate, and a low correlation between stock market returns and consumption growth. Moreover, the model has implications for expectations about future cash flows that are consistent with empirical findings.
Keywords: expectations, extrapolation, asset prices
JEL Classification: G02, G12
Suggested Citation: Suggested Citation