Working Paper: NBER ID: w1971
Authors: Robert P. Flood; Robert J. Hodrick; Paul Kaplan
Abstract: Several recent studies have attributed a large part of asset price volatility to self-fulfilling expectations. Such an explanation is unattractive to many since it allows allocations that need bear no particular relation to those implied by the economist's standard kit of \nmarket fundamentals. We examine the evidence presented in some of these \nstudies and find (i) that all of the bubble evidence can equally well be \ninterpreted as evidence of model misspecification and (ii) that a slight extension of standard econometric methods points very strongly toward model misspecification as the actual reason for the failure of simple models of market fundamentals to explain asset price volatility.
Keywords: stock market bubbles; asset price volatility; model misspecification
JEL Codes: G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| evidence attributed to stock market bubbles (E32) | model misspecification (C52) |
| failure of simple models to explain asset price volatility (C58) | existence of bubbles (E32) |
| variance bounds tests (C46) | presence of bubbles (E32) |
| use of risk-neutral utility functions (D11) | misleading conclusions about presence of bubbles (E32) |
| iterated Euler equations (C61) | rejection of risk-neutral model (D81) |