Self-fulfilling Asset Pricing

I develop an asset pricing model and show that collateral constraints that are common to the literature—ones that guarantee no loan loss—can generate multiple equilibria in a dynamic rational expectations economy. In the model, expectations of the future value of collateral affect leverage and thus investor demand for assets. High expected collateral value implies high leverage and hence high asset prices, which confirms the initial beliefs. And conversely for low collateral value. As a consequence, asset prices can be self-fulfilling. Price crashes and booms, excess volatility, long price recoveries, price overshooting and misfiring, as well as leverage cycles transpire purely from shifts in investor expectations without corresponding shifts in fundamentals (i.e., from sentiments).