Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model

Abstract

This paper presents a simple rational expectations model of intertemporal asset pricing. Heterogeneous risk aversion of investors is likely to generate declining aggregate relative risk aversion which leads to predictability of asset returns and high and persistent volatility. Stock market crashes may be observed if relative risk aversion differs strongly across investors. Then aggregate relative risk aversion may sharply increase given a small impairment in fundamentals so that asset prices may strongly decline. Changes in aggregate relative risk aversion may also lead to resistance and support levels as used in technical analysis. For numerical illustration we propose an analytical asset price formula.

Keywords: Aggregate relative risk aversion, Equilibrium asset price processes, Excess Volatility, Return predictability, Stock market crashes

JEL Classification: G12