Roberto Marfe’ (Swiss Finance Institute and University of Lausanne, Institute of Banking and Finance)

“Realized Expectations and the Equilibrium Risk-Return Trade Off”

abstract

This paper considers a simple, closed form and parsimonious continuous-time general equilibriummodel with investors featuring “catching up with the Joneses” preferences under incomplete information.Investors have unbiased beliefs about economic growth in the long-run, but underestimatelong-run reversion depending on the evolution of economic conditions as suggested by empirical evidencefrom the investors’ realized expectations about fundamentals. In turn, waves of optimism andpessimism alternate over time and produce a feedback effect which makes the perceived dynamicsof aggregate risk both more volatile and more persistent. Such joint formation of habit and beliefsprovides a rationale for the weak or negative risk-return trade off of the stock markets and its dynamics,in line with the investors’ realized expectations about returns from survey data but at oddswith leading asset pricing models. Furthermore, the model helps to explain the equity premium andthe risk-free rate puzzles, the smooth dynamics of the risk-free rate, the persistence of the dividendyield and the predictability of excess returns. Under a little but realistic amount of preference heterogeneity,the redistribution of wealth among the agents also produces endogenously the countercyclicalbehavior of the price of risk and of the equity premium.