Extrapolative asset pricing

Kai Li, Jun Liu

Research output: Contribution to journalArticlepeer-review

Abstract

This paper studies implications of return extrapolation in a consumption-based asset pricing model. We show that return extrapolation has strong implications for the pricing kernel. The time variation in the agent's return expectations is mainly reflected in the short rate and little in return volatility and equity premium. Return extrapolation causes return volatility and equity premium to be lower than the rational counterparts. In addition to the risk premium, the equity premium can include a sentiment premium that is due to dividend expectation bias rather than return extrapolation bias. Thus, time-varying dividend (rather than return) expectation bias helps produce a volatile equity premium. These results show that return extrapolation exacerbates asset pricing puzzles and fundamental extrapolation helps resolve puzzles.
Original languageEnglish
Article number105651
Pages (from-to)1-47
Number of pages47
JournalJournal of Economic Theory
Volume210
Early online date6 Apr 2023
DOIs
Publication statusPublished - Jun 2023

Keywords

  • Return extrapolation
  • Fundamental extrapolation
  • Asset pricing puzzles
  • Momentum
  • Sentiment

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