Asset pricing in production economies with extrapolative expectations

David Hirshleifer, Jun Li, Jianfeng Yu

Research output: Contribution to journalArticlepeer-review

22 Scopus citations

Abstract

Introducing extrapolative bias into a standard production-based model with recursive preferences reconciles salient stylized facts about business cycles (low consumption volatility, high investment volatility relative to output) and financial markets (high equity premium, volatile stock returns, low and smooth risk-free rate) with plausible levels of risk aversion and intertemporal elasticity of substitution. Furthermore, the model captures return predictability based upon dividend yield, Q, and investment. Intuitively, extrapolative bias increases the variation in the wealth-consumption ratio, which is heavily priced under recursive preferences; adjustment costs decrease the covariance between marginal utility and asset returns. Empirical support for key implications of the model is also provided.

Original languageEnglish (US)
Pages (from-to)87-106
Number of pages20
JournalJournal of Monetary Economics
Volume76
DOIs
StatePublished - Nov 1 2015

Bibliographical note

Publisher Copyright:
© 2015 Elsevier B.V.

Keywords

  • Extrapolation
  • Long-run risk
  • Production-based model
  • Recursive preferences

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