Empirical Rationality in the Stock Market

Peter Raahauge

Research output: Working paperResearch

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Abstract

Rational expectations models make stringent assumptions on the agent's knowledge about the true model. This paper introduces a model in which the rational agent realizes that using a given model involves approximation errors, and adjusts behavior accordingly. If the researcher accounts for this empirical rationality on part of the agent, the resulting empirical model assigns likelihood to the data actually observed, unlike in the unmodified rational expectations case. A Lucas( 1978)-type asset pricing model which incorporates empirical rationality is constructed and estimated using U.S.stock data. The equilibrium asset pricing function is seriously affected by the existence of approximation errors and the descriptive properties and normative implications of the model are significantly improved. This suggests that investors do not - and should not - ignore approximation errors.
Original languageEnglish
Place of PublicationAarhus
PublisherCentre for Analytical Finance. Aarhus School of Business. University of Aarhus
Number of pages32
Publication statusPublished - 2003
SeriesWorking Paper Series / Centre for Analytical Finance
Number141
ISSN1398-6163

Keywords

  • Approximation errors
  • Model uncertainty
  • Estimation of structural models
  • Rational expectations
  • Asset pricing

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