TY - UNPB
T1 - Endogenous Uncertainty and Market Volatility
AU - Motolese, Maurizio
AU - Kurz, Mordecai
PY - 2000
Y1 - 2000
N2 - In this paper we advance the theory that the distribution of beliefs in the market is the most
important propagation mechanism of economic volatility. Our model is based on the theory of
Rational Beliefs (RB) and Rational Belief Equilibrium (RBE) developed by Kurz [1994], [1997].
The paper argues that most of the observed volatility in financial markets is generated by the
beliefs of the agents and the diverse market puzzles which are examined in this paper, such as the
equity premium puzzle, are all driven by the structure of market expectations. To make the case
in support of our view, we present a single RBE model with which we study a list of phenomena
that have been viewed as "anomalies" in financial markets. The model is able to predict the correct
order of magnitude of:
(i) the long term mean and standard deviation of the price\dividend ratio;
(ii) the long term mean and standard deviation of the risky rate of return on equities;
(iii) the long term mean and standard deviation of the riskless rate;
(iv) the long term mean equity premium.
In addition, the model predicts
(v) the GARCH property of risky asset returns;
(vi) the observed pattern of the predictability of long returns on assets;
(vii) the Forward Discount Bias in foreign exchange markets.
The common economic explanation for these phenomena is the existence of heterogenous
agents with diverse but correlated beliefs. Given such diversity, some agents are optimistic and
some pessimistic about future capital gains. We develop a simple model which allows agents to
be in these two states of belief but the identity of the optimists and the pessimists fluctuates over
time since any agent may be in these two states of belief at any date. In this model there is a
unique parameterization under which the model makes all the above predictions simultaneously.
Any parameter choice in this small neighborhood requires the optimists to be in the majority but
the rationality of belief conditions of the RBE require the pessimists to have a higher intensity
level. This higher intensity has a decisive effect on the market: it increases the demand for
riskless assets, decreases the equilibrium riskless rate and increases the equity premium. In simple
terms, the large equity premium and the lower equilibrium riskless rate are the result of the fact
that at any moment of time there are agents who hold extreme pessimistic beliefs and they have a
relatively stronger impact on the market. The relative impact of these two groups of agents who
are, at any date, in the two states of belief is a direct consequence of the rationality of belief
conditions and in that sense it is unique to an RBE. The paper also studies the effect of
correlation of beliefs among investors. It shows that the main effect of such correlation is on the
dynamic patterns of asset prices and returns and is hence important for studying such phenomena
as stochastic volatility.
AB - In this paper we advance the theory that the distribution of beliefs in the market is the most
important propagation mechanism of economic volatility. Our model is based on the theory of
Rational Beliefs (RB) and Rational Belief Equilibrium (RBE) developed by Kurz [1994], [1997].
The paper argues that most of the observed volatility in financial markets is generated by the
beliefs of the agents and the diverse market puzzles which are examined in this paper, such as the
equity premium puzzle, are all driven by the structure of market expectations. To make the case
in support of our view, we present a single RBE model with which we study a list of phenomena
that have been viewed as "anomalies" in financial markets. The model is able to predict the correct
order of magnitude of:
(i) the long term mean and standard deviation of the price\dividend ratio;
(ii) the long term mean and standard deviation of the risky rate of return on equities;
(iii) the long term mean and standard deviation of the riskless rate;
(iv) the long term mean equity premium.
In addition, the model predicts
(v) the GARCH property of risky asset returns;
(vi) the observed pattern of the predictability of long returns on assets;
(vii) the Forward Discount Bias in foreign exchange markets.
The common economic explanation for these phenomena is the existence of heterogenous
agents with diverse but correlated beliefs. Given such diversity, some agents are optimistic and
some pessimistic about future capital gains. We develop a simple model which allows agents to
be in these two states of belief but the identity of the optimists and the pessimists fluctuates over
time since any agent may be in these two states of belief at any date. In this model there is a
unique parameterization under which the model makes all the above predictions simultaneously.
Any parameter choice in this small neighborhood requires the optimists to be in the majority but
the rationality of belief conditions of the RBE require the pessimists to have a higher intensity
level. This higher intensity has a decisive effect on the market: it increases the demand for
riskless assets, decreases the equilibrium riskless rate and increases the equity premium. In simple
terms, the large equity premium and the lower equilibrium riskless rate are the result of the fact
that at any moment of time there are agents who hold extreme pessimistic beliefs and they have a
relatively stronger impact on the market. The relative impact of these two groups of agents who
are, at any date, in the two states of belief is a direct consequence of the rationality of belief
conditions and in that sense it is unique to an RBE. The paper also studies the effect of
correlation of beliefs among investors. It shows that the main effect of such correlation is on the
dynamic patterns of asset prices and returns and is hence important for studying such phenomena
as stochastic volatility.
KW - Discount Bond
KW - Endogenous Uncertainty
KW - Equity premium
KW - Forward discount bias
KW - Garch
KW - Market Volatility
KW - Rational Belief Equilibrium
KW - Rational Beliefs
KW - Rational Expectations
KW - States of Belief
KW - Stock Price
KW - Discount Bond
KW - Endogenous Uncertainty
KW - Equity premium
KW - Forward discount bias
KW - Garch
KW - Market Volatility
KW - Rational Belief Equilibrium
KW - Rational Beliefs
KW - Rational Expectations
KW - States of Belief
KW - Stock Price
UR - http://hdl.handle.net/10807/14282
M3 - Working paper
BT - Endogenous Uncertainty and Market Volatility
ER -