Asset Pricing Theory In Macroeconomics

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This study attempts to link psychological research, empirical evidence, and asset-pricing theory to examine how investor sentiment affects financial market volatility. We provide insight into that question by exploring different parameter configurations using the general equilibrium model of Lucas [1978]. The Lucas model is the most influential asset-pricing model and has been of central importance to modern macroeconomics. Traditional economic analyses are based on the efficient markets hypothesis (EMH), which assumes that people price assets by measuring probability and using all available information, and hence leave little room for investor sentiment. As behavior is motivated by both thoughts and feelings, considering investor sentiment…show more content…
The most basic application of the Lucas model is to price equity in an economy with i.i.d. consumption growth and a representative infinitely lived and intertemporally maximizing consumer with time-separable utility. Over the past decades, numerous studies have investigated the effects of relaxing various assumptions of this model to explain financial market phenomena such as the remarkable variation in asset prices and expected stock returns, the development and bursting of bubbles, and the puzzling high equity premium. Mehra and Sah [2002] suggested that elasticity offers a simple but powerful representation of the influence of fluctuations in the denominator variable on the volatility of the numerator variable. More importantly, elasticity is unit-free, and thus can be considered a convenient measurement that captures sentiment induced fluctuations in financial markets. This section derives the elasticity of both equity and bill prices with respect to sentiment factors to explore the effect of sentiment fluctuations on asset price volatility. First, sentiment variations significantly influence equity price volatility. Second, both sentiment factors affect equity price volatility more than bill price volatility because the elasticity of equity prices to both sentiment factors exceeds that of bill prices. Third psychological research suggests that positive sentiment generally guides people to underestimate risk or take more risk. Fourth, the influence of sentiment fluctuations on equity price volatility is stronger when investors are less risk averse and more patient. The above analyses reveal that varying sentiment factors significantly influence price volatility for both assets. Shifting sentiment factors that influence equity and bill prices may also affect the expected returns of both assets.

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