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

Center of Finance and Econometrics No. 05/01l

EFA 2005 Moscow Meetings Paper

34 Pages Posted: 29 Jun 2005

See all articles by Guenter Franke

Guenter Franke

University of Konstanz - Department of Economics

Erik Lueders

Laval University; Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Date Written: June 28, 2005

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

Suggested Citation

Franke, Guenter and Lueders, Erik, Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model (June 28, 2005). Center of Finance and Econometrics No. 05/01l, EFA 2005 Moscow Meetings Paper, Available at SSRN: https://ssrn.com/abstract=673511 or http://dx.doi.org/10.2139/ssrn.673511

Guenter Franke (Contact Author)

University of Konstanz - Department of Economics ( email )

Fach 147
Konstanz, 78457
Germany
+49 7531 88 2545 (Phone)
+49 7531 88 3559 (Fax)

Erik Lueders

Laval University ( email )

Quebec G1K 7P4
Canada

Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE)

Ste-Foy, Quebec G1K 7P4
Canada

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