Working Paper
High equity premia and crash fears. Rational foundations
Abstract: We show that when in Lucas trees 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: Assets (Accounting); Rational expectations (Economic theory);
Status: Published in Economic Theory, October 2006, 28(3), pp. 693-708
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Bibliographic Information
Provider: Federal Reserve Bank of St. Louis
Part of Series: Working Papers
Publication Date: 2005
Number: 2005-011