This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own "uncertainty" on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, "leverage effects," excess volatility, and time-varying expected returns.

[This article presents a dynamic, rational expectations equilibrium model of asset prices where the drift of fundamentals (dividends) shifts between two unobservable states at random times. I show that in equilibrium, investors' willingness to hedge against changes in their own "uncertainty" on the true state makes stock prices overreact to bad news in good times and underreact to good news in bad times. I then show that this model is better able than conventional models with no regime shifts to explain features of stock returns, including volatility clustering, "leverage effects," excess volatility, and time-varying expected returns.]

Shocks to equity options' implied volatility are followed by persistently lower short-term rates. Shocks to puts' over calls' out-of-the-money implied volatilities (P/C) are followed by persistently higher rates. Stock and Treasury bond implied volatilities, which measure market and policy uncertainty, are countercyclical, while P/C, which measures downside risk, is procyclical. An equilibrium model in which investors and the central bank learn about composite regimes of economic and policy variables explains these dynamics, linking them to a learning-based, forward-looking Taylor rule. Survey data support our model's predictions on the effect of uncertainty on the level and fluctuations of implied volatilities.

We propose a novel economic mechanism that generates stock return predictability in both the time series and the cross-section. Investors' income has two sources, wages and dividends that grow stochastically over time. As a consequence the fraction of total income produced by wages fluctuates depending on economic conditions. We show that the risk premium that investors require to hold stocks varies with these fluctuations. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and large adjusted R2s. Tests of the model's cross-sectional predictions on the set of 25 Fama-French portfolios sorted on size and book-to-market are also met with considerable support.

We propose a novel economic mechanism that generates stock return predictability in both the time series and the cross-section. Investors’ income has two sources, wages and dividends that grow stochastically over time. As a consequence the fraction of total income produced by wages fluctuates depending on economic conditions. We show that the risk premium that investors require to hold stocks varies with these fluctuations. A regression of stock returns on lagged values of the labor income to consumption ratio produces statistically significant coefficients and large adjusted R2s. Tests of the model’s cross-sectional predictions on the set of 25 Fama–French portfolios sorted on size and book-to-market are also met with considerable support.

[We develop a model of the optimal initial public offering (IPO) decision in the presence of learning about the average profitability of a private firm. The entrepreneur trades off diversification benefits of going public against benefits of private control. Going public is optimal when the firm's expected future profitability is sufficiently high. The model predicts that firm profitability should decline after the IPO, on average, and that this decline should be larger for firms with more volatile profitability and firms with less uncertain average profitability. These predictions are supported empirically in a sample of 7183 IPOs in the United States between 1975 and 2004.]

Shocks to equity options' implied volatility are followed by persistently lower short-term rates. Shocks to puts' over calls' out-of-the-money implied volatilities (P/C) are followed by persistently higher rates. Stock and Treasury bond implied volatilities, which measure market and policy uncertainty, are countercyclical, while P/C, which measures downside risk, is procyclical. An equilibrium model in which investors and the central bank learn about composite regimes of economic and policy variables explains these dynamics, linking them to a learning-based, forward-looking Taylor rule. Survey data support our model's predictions on the effect of uncertainty on the level and fluctuations of implied volatilities.

We develop a model of the optimal initial public offering (IPO) decision in the presence of learning about the average profitability of a private firm. The entrepreneur trades off diversification benefits of going public against benefits of private control. Going public is optimal when the firm's expected future profitability is sufficiently high. The model predicts that firm profitability should decline after the IPO, on average, and that this decline should be larger for firms with more volatile profitability and firms with less uncertain average profitability. These predictions are supported empirically in a sample of 7183 IPOs in the United States between 1975 and 2004. The Author 2008. Published by Oxford University Press on behalf of The Society for Financial Studies. All rights reserved. For Permissions, please email: [email protected], Oxford University Press.