TAILIEUCHUNG - Equilibrium stock return dynamics under alternative rules of learning about hidden states

More recently, Granger (1986) and Johansen and Juselius (1990) proposed to determine the existence of long-term equilibrium among selected variables through cointegration analysis, paving the way for a (by now) preferred approach to examining the economic variables-stock markets relationship. A set of time-series variables are cointegrated if they are integrated of the same order and a linear combination of them is stationary. Such linear combinations would then point to the existence of a long-term relationship between the variables. An advantage of cointegration analysis is that through building an error-correction model (ECM), the dynamic co-movement among variables and the. | Available online at _ JOURNAL OF sciENCE g DiRECT- Economic Dynamics _ . Control ELSEVIER Journal of Economic Dynamics Control 28 2004 1925-1954 ------- locate econbase Equilibrium Sl z ck return dynamics under alternative rules of learning about hMden states Michael w. Brandta Qi Zengb Lu Zhangc T9FuquarSwoio2tusinese Dtd Uoiirsityand NBER uCm NC fE S c Uversity of Melbourne Melbourne VIC 3010 Australia iUiio0. iisve iOnicISxd d BusỉnesoASnỉnỉstra on UnỉversỉtyoNNocIester R chester NY 14627 USA Riueived 6 At ust8 ee2 accepted Septemben 200C Ab stract . We examine the properties of equilibrium stock returns in an economy in which agents need to learn the hidden state of die endowment proceed. We cocsider Bayesian and suboptimal learning rules including near-rational learning conservatism representativeness optimism and pessimism. Bayesian learning produces realistic variation in the conditional equity risk premium return volatility and Sharpe ratio. Alternative learning behaviors alter significantly the level and variation of the conditional return moments. However when agents are allowed to be conscious of ftiirleacsmg mistakeland tuprice asscis aNcordioogly. thspropirttescf rcAenta undeeBeeyesmn akdahnmctwc Icarningrnlus ane vữtNiullymdistingo hable. uo 20Ad Iiu . dinrightsueserv rL man dasuUfiasuShEn GN G 2 GOe f Of. . . f ja-Wu Time-varaiagmomenta or returns Behaviornlbiases The eqmty riskprxmmm us andunderstanding why and how it varies is a lively research field. Intuitively there are two reasons for the risk premium to vary in a rational expectations equilibrium REE framework either the compensa-tionrequirvdby agents to take on a marginal unit of risk the market price of risk changes or the amount of risk in the economy changes. It is relatively straightforward to unireiFti engodengutchctgea intfe mGkerprinenf rieGNSGdugCchGngrng aggregate CosrAspondingAuthOT. eor S-909 .

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