Working Paper: NBER ID: w7699
Authors: Jonathan Lewellen; Jay Shanken
Abstract: In asset pricing, estimation risk refers to investor uncertainty about the parameters of the return or cashflow process. We show that with estimation risk the observable properties of prices and returns can differ significantly from the properties perceived by rational investors. In particular, parameter uncertainty will tend to induce return predictability in ways that resemble irrational mispricing, and prices can violate familiar volatility bounds when investors are rational. Cross-sectionally, expected returns deviate from the CAPM even if investors attempt to hold mean-variance efficient portfolios, and these deviations can be predictable based on past dividends and prices. In short, estimation risk can be important for characterizing and testing market efficiency.
Keywords: No keywords provided
JEL Codes: C11; D83; G12; G14
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| estimation risk (C13) | observable properties of prices and returns (G12) |
| observable properties of prices and returns (G12) | predictability mistaken for irrational mispricing (G41) |
| estimation risk (C13) | predictability of returns (G17) |
| predictability of returns (G17) | observable market phenomena (G10) |
| estimation risk (C13) | investor beliefs (G41) |
| investor beliefs (G41) | observable market behavior (G10) |
| excess stock returns (G12) | predictability even with rational risk-neutral investors (D81) |