Authors: Kai Li (Institute of Financial Studies, Southwestern University of Finance and Economics; Department of Applied Finance, Macquarie University), Jun Liu (Rady School of Management, University of California San Diego)
Abstract:
This paper studies implications of return extrapolation in a consumption-based asset pricing model. We show that return extrapolation has strong implications for the pricing kernel. The time variation in the agen-t’s return expectations is mainly reflected in the short rate and little in return volatility and equity premium. Return extrapolation causes return volatility and equity premium to be lower than the rational counter-parts. In addition to the risk premium, the equity premium can include a sentiment premium that is due to dividend expectation bias rather than return extrapolation bias. Thus, time-varying dividend (rather than re-turn) expectation bias helps produce a volatile equity premium. These results show that return extrapolation exacerbates asset pricing puzzles and fundamental extrapolation helps resolve puzzles.
