Return Predictability and Stock Market Crashes in a Simple Rational Expectations Model

Abstract

This paper presents a simple rational expectations model of in-
tertemporal asset pricing. It shows that heterogeneous risk aversion
of investors is likely to generate declining aggregate relative risk aver-
sion. This leads to predictability of asset returns and high and persis-
tent volatility. Stock market crashes may be observed if relative risk
aversion differs strongly across investors. Then aggregate relative risk
aversion may sharply increase given a small impairment in fundamen-
tals so that asset prices may strongly decline. Changes in aggregate
relative risk aversion may also lead to resistance and support levels as
used in technical analysis. For numerical illustration we propose an
analytical asset price formula.

JEL classification: G12

Keywords: Aggregate relative risk aversion, Equilibrium asset price
processes, Excess Volatility, Return predictability, Stock market crashes

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