Stocks returns are $8\%$ per year higher than bond returns on average. It's hard to explain such a large equity premium using the standard consumption-based model because consumption growth isn't risky enough. So, to fix this problem, modern … [Continue reading]
Factor Models, Little Green Men, And Machine Learning
Economists use machine learning (ML) to study asset prices in two different ways. Approach #1: use these techniques to predict the cross-section of expected returns---i.e., to predict which stocks are most likely to have high or low future returns. … [Continue reading]
Risk-Factor Identification: A Critique
In standard cross-sectional asset-pricing models, expected returns are governed by exposure to aggregate risk factors in a market populated by fully rational investors. Here's how these models work. Because investors are fully rational, they … [Continue reading]
The Basic Recipe For Rationalizing Errors In Belief
Behavioral-finance models are often written down so that, although each individual trader holds incorrect beliefs, market events nevertheless unfold in such a way that traders can rationalize their own errors. e.g., consider the model in Scheinkman … [Continue reading]
The Existence Of A Bubble vs. The Timing Of Its Crash
Journalists love to talk about bubbles. The Wall Street Journal has hinted at bubbles in both the Chinese stock market and the market for Bitcoin during the past month alone. But, financial economists are much more reluctant to call something a … [Continue reading]