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Extrapolative asset pricing

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  • Li, Kai
  • Liu, Jun

Abstract

This paper studies implications of return extrapolation in a consumption-based asset pricing model. We show that return extrapolation has strong implications for the pricing kernel. The time variation in the agent's return expectations is mainly reflected in the short rate and little in return volatility and equity premium. Return extrapolation causes return volatility and equity premium to be lower than the rational counterparts. In addition to the risk premium, the equity premium can include a sentiment premium that is due to dividend expectation bias rather than return extrapolation bias. Thus, time-varying dividend (rather than return) expectation bias helps produce a volatile equity premium. These results show that return extrapolation exacerbates asset pricing puzzles and fundamental extrapolation helps resolve puzzles.

Suggested Citation

  • Li, Kai & Liu, Jun, 2023. "Extrapolative asset pricing," Journal of Economic Theory, Elsevier, vol. 210(C).
    • Handle: RePEc:eee:jetheo:v:210:y:2023:i:c:s0022053123000479
    DOI: 10.1016/j.jet.2023.105651
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    Cited by:

    1. Adem Atmaz & Huseyin Gulen & Stefano Cassella & Fangcheng Ruan, 2024. "Contrarians, Extrapolators, and Stock Market Momentum and Reversal," Management Science, INFORMS, vol. 70(9), pages 5949-5984, September.

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    More about this item

    Keywords

    Return extrapolation; Fundamental extrapolation; Asset pricing puzzles; Momentum; Sentiment;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates

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