We show the dynamics of diverse beliefs is the primary propagation mechanism of volatility in asset markets. Hence, we treat the characteristics of the market beliefs as a primary, primitive, explanation of market volatility. We study an economy with stock and riskless bond markets and formulate a financial equilibrium model with diverse and time varying beliefs. Agents¿ states of belief play a key role in the market, requiring an endogenous expansion of the state space. To forecast prices agents must forecast market states of belief which are beliefs of "others" hence our equilibrium embodies the Keynes "Beauty Contest." A "market state of belief" is a vector which uniquely identifies the distribution of conditional probabilities of agents. Restricting beliefs to satisfy the rationality principle of Rational Belief (see Kurz, 1994, 1997) our economy replicates well the empirical record of the (i) moments of the price/dividend ratio, risky stock return, riskless interest rate and the equity premium; (ii) Sharpe ratio and the correlation between risky returns and consumption growth; (iii) predictability of stock returns and price/dividend ratio as expressed by: (I)Variance Ratio statistic for long lags, (II) autocorrelation of these variables, and (III) mean reversion of the risky returns and the predictive power of the price/dividend ratio. Also, our model explains the presence of stochastic volatility in asset prices and returns. Two properties of beliefs drive market volatility: (i) rationalizable over confidence implying belief densities with fat tails, and (ii) rationalizable asymmetry in frequencies of bull or bear states.

Motolese, M., Kurz, M., Jin, H., Determinants of stock market volatility and risk premia., <<ANNALS OF FINANCE>>, 2005; 1 (2): 109-147. [doi:10.1007/s10436-004-0004-5] [http://hdl.handle.net/10807/14230]

Determinants of stock market volatility and risk premia.

Motolese, Maurizio;
2005

Abstract

We show the dynamics of diverse beliefs is the primary propagation mechanism of volatility in asset markets. Hence, we treat the characteristics of the market beliefs as a primary, primitive, explanation of market volatility. We study an economy with stock and riskless bond markets and formulate a financial equilibrium model with diverse and time varying beliefs. Agents¿ states of belief play a key role in the market, requiring an endogenous expansion of the state space. To forecast prices agents must forecast market states of belief which are beliefs of "others" hence our equilibrium embodies the Keynes "Beauty Contest." A "market state of belief" is a vector which uniquely identifies the distribution of conditional probabilities of agents. Restricting beliefs to satisfy the rationality principle of Rational Belief (see Kurz, 1994, 1997) our economy replicates well the empirical record of the (i) moments of the price/dividend ratio, risky stock return, riskless interest rate and the equity premium; (ii) Sharpe ratio and the correlation between risky returns and consumption growth; (iii) predictability of stock returns and price/dividend ratio as expressed by: (I)Variance Ratio statistic for long lags, (II) autocorrelation of these variables, and (III) mean reversion of the risky returns and the predictive power of the price/dividend ratio. Also, our model explains the presence of stochastic volatility in asset prices and returns. Two properties of beliefs drive market volatility: (i) rationalizable over confidence implying belief densities with fat tails, and (ii) rationalizable asymmetry in frequencies of bull or bear states.
eng
http://www.springerlink.com/content/fcb6da5n2m9vmcy1/
Motolese, M., Kurz, M., Jin, H., Determinants of stock market volatility and risk premia., <>, 2005; 1 (2): 109-147. [doi:10.1007/s10436-004-0004-5] [http://hdl.handle.net/10807/14230]
File in questo prodotto:
File Dimensione Formato  
Determinants of Market Volatility and Risk Premia (swp04001).pdf

accesso aperto

Descrizione: Pre-Published version
Dimensione 665.48 kB
Formato Adobe PDF
665.48 kB Adobe PDF Visualizza/Apri

I documenti in IRIS sono protetti da copyright e tutti i diritti sono riservati, salvo diversa indicazione.

Utilizza questo identificativo per citare o creare un link a questo documento: http://hdl.handle.net/10807/14230
Citazioni
  • ???jsp.display-item.citation.pmc??? ND
  • Scopus 20
  • ???jsp.display-item.citation.isi??? ND
social impact