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American Economic Review Vol. 90 No. 4 2000

Asset Pricing with Distorted Beliefs: Are Equity Returns Too Good to Be True?

Stephen G. Cecchetti1; Pok-Sang Lam2; Nelson C. Mark2

1 Department of Economics, 410 Arps Hall, Ohio State University, 1945 North High Street, Columbus, OH 43210, National Bureau of Economic Research. · 2 Department of Economics, 410 Arps Hall, Ohio State University, 1945 North High Street, Columbus, OH 43210.

Abstract

We study a Lucas asset-pricing model that is standard in all respects, except that the representative agent's subjective beliefs about endowment growth are distorted. Using constant relative risk-aversion (CRRA) utility, with a CRRA coefficient below 10; fluctuating beliefs that exhibit, on average, excessive pessimism over expansions; and excessive optimism over contractions (both ending more quickly than the data suggest), our model is able to match the first and second moments of the equity premium and risk-free rate, as well as the persistence and predictability of excess returns found in the data.

DOI
10.1257/aer.90.4.787
Volume
90
Issue
4
Pages
787-805
Language
en
Sources
bibtex:phds-export.bib openalex crossref

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