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Learning and Stock Market Volatility

Author

Listed:
  • Klaus Adam

    (Research Department CEPR and European Central Bank)

  • Albert Marcet
  • Juan Pablo Nicolini
Abstract
Introducing learning into a standard asset pricing model improves considerably its empirical performance. In a model of learning where today's stock price is determined by the expectation of tomorrow's stock price, the dynamics of expectations and actual price are such that the market has inertia. If the market has been increasing it will have a tendency to increase further, thereby generating large and persistent deviations of asset prices from fundamental values. For overvalued asset prices the model predicts the possibility of sudden and strong price decreases, i.e., 'stock market crashes', but no symmetric stock market increases in the presence of undervalued asset prices. These features emerge even though the deviations of agents' price expectations from perfectly rational return forecasts would be hard to detect given available sample sizes. Using a calibrated asset pricing model with habit persistence and learning, we can match the following quarterly U.S. asset pricing facts: the mean and volatility of stock returns; the mean, volatility, and autocorrelation of the price dividend ratio; and the average bond returns (equity premium). Consistent with empirical studies, the learning model also predicts that the price dividend ratio has predictive power for stock returns over the medium term (but not the short-term) and is unrelated to future fundamentals. The same model under rational expectations generates insufficient volatility and auto-correlation of the price dividend ratio and implies that the price dividend ratio is unrelated to future stock returns. The learning and rational expectations models both predict too much volatility of the short-term real interest rate, although the learning model performs somewhat better on this account.

Suggested Citation

  • Klaus Adam & Albert Marcet & Juan Pablo Nicolini, 2006. "Learning and Stock Market Volatility," Computing in Economics and Finance 2006 15, Society for Computational Economics.
    • Handle: RePEc:sce:scecfa:15
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    Citations

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    Cited by:

    1. Klaus Adam & Pei Kuang & Albert Marcet, 2012. "House Price Booms and the Current Account," NBER Macroeconomics Annual, University of Chicago Press, vol. 26(1), pages 77-122.
    2. Eva Carceles-Poveda & Chryssi Giannitsarou, 2008. "Asset Pricing with Adaptive Learning," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(3), pages 629-651, July.
    3. George W. Evans, 2011. "Comment on "Natural Expectations, Macroeconomic Dynamics, and Asset Pricing"," NBER Chapters, in: NBER Macroeconomics Annual 2011, Volume 26, pages 61-71, National Bureau of Economic Research, Inc.
    4. Adam, Klaus & Marcet, Albert, 2011. "Internal rationality, imperfect market knowledge and asset prices," Journal of Economic Theory, Elsevier, vol. 146(3), pages 1224-1252, May.
    5. William A. Branch & George W. Evans, 2011. "Learning about Risk and Return: A Simple Model of Bubbles and Crashes," American Economic Journal: Macroeconomics, American Economic Association, vol. 3(3), pages 159-191, July.
    6. Eva Carceles-Poveda & Chryssi Giannitsarou, 2008. "Asset Pricing with Adaptive Learning," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 11(3), pages 629-651, July.
    7. Orlando Gomes, 2009. "Stability under learning: the neo-classical growth problem," Economics Bulletin, AccessEcon, vol. 29(4), pages 3186-3193.
    8. Detken, Carsten & Adalid, Ramón, 2007. "Liquidity shocks and asset price boom/bust cycles," Working Paper Series 732, European Central Bank.
    9. Klaus Adam & Albert Marcet, 2010. "Booms and Busts in Asset Prices," IMES Discussion Paper Series 10-E-02, Institute for Monetary and Economic Studies, Bank of Japan.
    10. Francesco Caprioli & Pietro Rizza & Pietro Tommasino, 2011. "Optimal Fiscal Policy when Agents Fear Government Default," Revue économique, Presses de Sciences-Po, vol. 62(6), pages 1031-1043.
    11. Cogley, Timothy & Sargent, Thomas J., 2008. "The market price of risk and the equity premium: A legacy of the Great Depression?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 454-476, April.
    12. Chakraborty, Avik & Evans, George W., 2008. "Can perpetual learning explain the forward-premium puzzle?," Journal of Monetary Economics, Elsevier, vol. 55(3), pages 477-490, April.
    13. Georges, Christophre, 2008. "Staggered updating in an artificial financial market," Journal of Economic Dynamics and Control, Elsevier, vol. 32(9), pages 2809-2825, September.
    14. Marcet, Albert & Adam, Klaus, 2009. "Internal Rationality and Asset Prices," CEPR Discussion Papers 7498, C.E.P.R. Discussion Papers.

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