Empirical Rationality in the Stock Market

Research output: Working paperResearch

1 Downloads (Pure)

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

Cite this

Raahauge, P. (2003). Empirical Rationality in the Stock Market. Aarhus: Centre for Analytical Finance. Aarhus School of Business. University of Aarhus. Working Paper Series / Centre for Analytical Finance, No. 141
Raahauge, Peter. / Empirical Rationality in the Stock Market. Aarhus : Centre for Analytical Finance. Aarhus School of Business. University of Aarhus, 2003. (Working Paper Series / Centre for Analytical Finance; No. 141).
@techreport{ae7125a2292d4aba9f7c50ca6f815d0a,
title = "Empirical Rationality in the Stock Market",
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.",
keywords = "Aktiemarkeder, Asset pricing, Rational expectations, Approximation errors, Model uncertainty, Estimation of structural models, Rational expectations, Asset pricing",
author = "Peter Raahauge",
year = "2003",
language = "English",
series = "Working Paper Series / Centre for Analytical Finance",
publisher = "Centre for Analytical Finance. Aarhus School of Business. University of Aarhus",
number = "141",
address = "Denmark",
type = "WorkingPaper",
institution = "Centre for Analytical Finance. Aarhus School of Business. University of Aarhus",

}

Raahauge, P 2003 'Empirical Rationality in the Stock Market' Centre for Analytical Finance. Aarhus School of Business. University of Aarhus, Aarhus.

Empirical Rationality in the Stock Market. / Raahauge, Peter.

Aarhus : Centre for Analytical Finance. Aarhus School of Business. University of Aarhus, 2003.

Research output: Working paperResearch

TY - UNPB

T1 - Empirical Rationality in the Stock Market

AU - Raahauge, Peter

PY - 2003

Y1 - 2003

N2 - 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.

AB - 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.

KW - Aktiemarkeder

KW - Asset pricing

KW - Rational expectations

KW - Approximation errors

KW - Model uncertainty

KW - Estimation of structural models

KW - Rational expectations

KW - Asset pricing

M3 - Working paper

T3 - Working Paper Series / Centre for Analytical Finance

BT - Empirical Rationality in the Stock Market

PB - Centre for Analytical Finance. Aarhus School of Business. University of Aarhus

CY - Aarhus

ER -

Raahauge P. Empirical Rationality in the Stock Market. Aarhus: Centre for Analytical Finance. Aarhus School of Business. University of Aarhus. 2003.