Model Complexity, Expectations, and Asset Prices

45 Pages Posted: 1 Feb 2021 Last revised: 18 Nov 2021

See all articles by Pooya Molavi

Pooya Molavi

Northwestern University

Alireza Tahbaz-Salehi

Northwestern University - Kellogg School of Management; Centre for Economic Policy Research (CEPR)

Andrea Vedolin

Boston University - Department of Finance & Economics

Multiple version iconThere are 3 versions of this paper

Date Written: January 2021

Abstract

This paper analyzes how limits to the complexity of statistical models used by market participants can shape asset prices. We consider an economy in which agents can only entertain models with at most k factors, where k may be distinct from the true number of factors that drive the economy’s fundamentals. We first characterize the implications of the resulting departure from rational expectations for return dynamics and relate the extent of return predictability at various horizons to the number of factors in the agents’ models and the statistical properties of the underlying data-generating process. We then apply our framework to two applications in asset pricing: (i) violations of uncovered interest rate parity at different horizons and (ii) momentum and reversal in equity returns. We find that constraints on the complexity of agents’ models can generate return predictability patterns that are consistent with the data.

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Suggested Citation

Molavi, Pooya and Tahbaz-Salehi, Alireza and Vedolin, Andrea, Model Complexity, Expectations, and Asset Prices (January 2021). NBER Working Paper No. w28408, Available at SSRN: https://ssrn.com/abstract=3776977 or http://dx.doi.org/10.2139/ssrn.3776977

Pooya Molavi (Contact Author)

Northwestern University ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Alireza Tahbaz-Salehi

Northwestern University - Kellogg School of Management ( email )

2001 Sheridan Road
Evanston, IL 60208
United States

Centre for Economic Policy Research (CEPR) ( email )

London
United Kingdom

Andrea Vedolin

Boston University - Department of Finance & Economics ( email )

595 Commonwealth Avenue
Boston, MA 02215
United States

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