Bubblesandcrashes:Gradientdynamicsinï¬nancial markets (original) (raw)
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We develop a financial market model focused on fund managers who continuously adjust their exposure to risk in response to the payo gradient. The base model has a stable equilibrium with classic properties. However, bubbles and crashes occur in extended models incorporating an endogenous market risk premium based on investors' historical losses and constant gain learning. When losses have been
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This paper demonstrates that an asset pricing model with least-squares learning can lead to bubbles and crashes as endogenous responses to the fundamentals driving asset prices. When agents are risk-averse they generate forecasts of the conditional variance of a stock's return. Recursive updating of the conditional variance and expected return implies two mechanisms through which learning impacts stock prices: occasional shocks may lead agents to lower their risk estimate and increase their expected return, thereby triggering a bubble; along a bubble path recursive estimates of risk will increase and crash the bubble. JEL Classifications: G12; G14; D82; D83
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A simple model for asset price bubble formation and collapse
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