Rational Roots of Volatile Excess Volatility

Abstract

Market prices tend to be significantly more volatile than the dividends they discount. Furthermore, volatility is not stable; it alternates between calm periods and storms of varying duration and intensity. These behaviors are often viewed as market defects or symptoms of the madness of crowds. In fact, rational learning about unstable drift provides a unified explanation. High earnings rationally breed optimism about future growth while low earnings rationally breed pessimism. This breeds excess volatility, roughly in proportion to the volatile variance of beliefs. The impact is highly significant in models fit to empirical evidence on GDP disaster risks.

Keywords: equity pricing, excess volatility, GARCH behavior, irrational exuberance, rational learning, disaster risks, doubt

JEL Classification: G12, G14, G41