Extrapolative Expectations and the Equity Premium
نویسنده
چکیده
Many stockholders irrationally believe that high recent market returns predict high future market returns. I argue that the presence of these extrapolative investors can help resolve the equity premium puzzle if the elasticity of intertemporal substitution (EIS) is greater than unity. Extrapolators’ overreaction to dividend news generates countercyclical expected returns. Rational investors respond by making their consumption growth more procyclical. The equity premium is high because extrapolators believe stocks are a bad hedge and rational investors have high consumption growth covariance with stocks. I match the U.S. data with a relative risk aversion of 4 and an EIS of 2. JEL classification: D51, E44, G12
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