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Return predictability and stock market crashes in a simple rational expectation models

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  • Franke, Günter
  • Lüders, Erik

Abstract

This paper presents a simple rational expectations model of intertemporal asset pricing. It shows that state-independent heterogeneous risk aversion of investors is likely to generate declining aggregate relative risk aversion. This leads to predictability of asset returns and high and persistent volatility. Stock market crashes may be observed if relative risk aversion differs strongly across investors. Then aggregate relative risk aversion may sharply increase given a small impairment in fundamentals so that asset prices may strongly decline. Changes in aggregate relative risk aversion may also lead to resistance and support levels as used in technical analysis. For numerical illustration we propose an analytical asset price formula.

Suggested Citation

  • Franke, Günter & Lüders, Erik, 2006. "Return predictability and stock market crashes in a simple rational expectation models," CoFE Discussion Papers 06/05, University of Konstanz, Center of Finance and Econometrics (CoFE).
    • Handle: RePEc:zbw:cofedp:0605
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    References listed on IDEAS

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    Cited by:

    1. Franke, Günter & Weber, Thomas, 2006. "Wieweit tragen rationale Modelle in der Finanzmarktforschung?," CoFE Discussion Papers 06/09, University of Konstanz, Center of Finance and Econometrics (CoFE).

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    More about this item

    Keywords

    Aggregate relative risk aversion; Equilibrium asset price processes; Excess Volatility; Return predictability; Stock market crashes;
    All these keywords.

    JEL classification:

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

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