Lock-In of Extrapolative Expectations in an Asset Pricing Model
44 Pages Posted: 1 Aug 2004
There are 2 versions of this paper
Lock-In of Extrapolative Expectations in an Asset Pricing Model
Lock-In of Extrapolative Expectations in an Asset Pricing Model
Date Written: July 30, 2004
Abstract
This paper examines an agent's choice of forecast method within a standard asset pricing model. To make a conditional forecast, a representative agent may choose one of the following: (1) a rational (or fundamentals-based) forecast that employs knowledge of the stochastic process governing dividends, (2) a constant forecast based on a simple long-run average of the forecast variable, or (3) a time-varying forecast that extrapolates from the last observation of the forecast variable. I show that an agent who is concerned about minimizing forecast errors may inadvertently become locked-in to an extrapolative forecast. In particular, the initial use of extrapolation shifts the moments of the forecast variable so that the agent perceives no accuracy gain from switching to one of the alternative forecast methods. Within the same basic framework, I demonstrate the possibility of endogenous switching between forecast methods when the agent is concerned about minimizing recent forecast errors. In quantitative simulations, the model can generate excess volatility of stock prices, time-varying volatility of returns, long-horizon predictability of returns, bubbles driven by optimism about the future, and market crashes that restore attention to fundamentals. All of these features appear to be present in long-run U.S. stock market data.
Keywords: Asset pricing, distorted beliefs, expectations, bubbles, excess volatility
JEL Classification: E44, G12
Suggested Citation: Suggested Citation
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