Equilibrium Stock Return Dynamics Under Alternative Rules of Learning About Hidden States

38 Pages Posted: 22 Aug 2003

See all articles by Michael W. Brandt

Michael W. Brandt

Duke University - Fuqua School of Business; National Bureau of Economic Research (NBER)

Qi Zeng

University of Melbourne - Department of Finance; Financial Research Network (FIRN)

Lu Zhang

Ohio State University - Fisher College of Business; National Bureau of Economic Research (NBER)

Date Written: August 2003

Abstract

We examine the properties of equilibrium stock returns in an incomplete information economy in which agents need to learn the hidden state of the endowment process. Both Bayesian and suboptimal learning rules are considered, including near-rational learning, conservatism, representativeness, optimism, and pessimism. We demonstrate that Bayesian learning performs reasonably well in producing realistic variation in the conditional equity risk premium, return volatility, and Sharpe ratio. Alternative learning behaviors alter significantly both the level and time-variation of the conditional moments of returns. However, when we allow the agents to be conscious of their learning mistakes and to price assets accordingly, the properties of equilibrium stock returns under alternative learning are virtually indistinguishable from those under Bayesian learning.

Suggested Citation

Brandt, Michael W. and Zeng, Qi and Zhang, Lu, Equilibrium Stock Return Dynamics Under Alternative Rules of Learning About Hidden States (August 2003). Simon Business School Working Paper No. FR 03-24, Available at SSRN: https://ssrn.com/abstract=437661 or http://dx.doi.org/10.2139/ssrn.437661

Michael W. Brandt (Contact Author)

Duke University - Fuqua School of Business ( email )

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National Bureau of Economic Research (NBER)

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Qi Zeng

University of Melbourne - Department of Finance ( email )

Faculty of Economics and Commerce
Parkville, Victoria 3010 3010
Australia

Financial Research Network (FIRN)

C/- University of Queensland Business School
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Queensland
Australia

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Lu Zhang

Ohio State University - Fisher College of Business ( email )

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United States
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National Bureau of Economic Research (NBER)

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