High Equity Premia and Crash Fears: Rational Foundations

18 Pages Posted: 9 May 2004

See all articles by Massimo Guidolin

Massimo Guidolin

Bocconi University, Dept. of Finance; Bocconi University - CAREFIN - Centre for Applied Research in Finance

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Date Written: August 16, 2004

Abstract

We show that when in Lucas model the process for dividends is described by a lattice tree subject to infrequent but observable structural breaks, in equilibrium recursive rational learning may inflate the equity risk premium and reduce the risk-free interest rate for low levels of risk aversion. The key condition for these results to obtain is the presence of sufficient initial pessimism. The relevance of these findings is magnified by the fact that under full information our artificial economy cannot generate asset returns matching the empirical evidence for any positive relative risk aversion.

Keywords: Rational learning, equilibrium asset returns, structural breaks

JEL Classification: G12, D83

Suggested Citation

Guidolin, Massimo, High Equity Premia and Crash Fears: Rational Foundations (August 16, 2004). Available at SSRN: https://ssrn.com/abstract=448081 or http://dx.doi.org/10.2139/ssrn.448081

Massimo Guidolin (Contact Author)

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